John Bogle on Mistakes & Learning

Investing with Simplicity Speech by John C. Bogle Senior Chairman and Founder, The Vanguard Group ~ ~ ~ The Personal Finance Conference The Washington Post Washington, D.C. January 30, 1999 Many of you have heard the ancient Chinese curse---<:urse, mind you-that says, "may you live in interesting times." Curse or not, surely this is as interesting a time as it is possible to imagine. The extraordinary volatility in the financial markets is just one example of the stepped-up pace of our lives in an era-·a new era, to be sure-in which the technology revolution, the information explosion, and the rise of global interdependence have altered almost every activity in our daily lives. In important measure, it is these developments that have brought most investors unprecedented prosperity and wealth accumulation, and helped make mutual funds the investment of choice among American families. You now have all the information you could possibly need---except, of course, information about the future course of events and markets-to make investment decisions. But you should not mistake information for knowledge ... nor should you ever, ever mistake knowledge for wisdom, the ultimate weapon of the intelligent investor. During this "Personal Finance" conference, you'll hear a lot of good common sense. Pay attention to it. But you'll also hear a considerable amount of investment wizardry, financial legerdemain, and tempting solutions, often from the apparently omniscient. Disregard it.

But the fact of the matter is that something has gone profoundly wrong with the very system that we have come to know as American capitalism. To maintain the earlier metaphor, the very barrel that holds all of those apples, good and bad alike, has itself developed some major cracks, and is in need of major repair. All of us involved in investor relations have our work cut out for us. I use “us” deliberately, for that’s one of the roles I have played from the time I answered my first letter from an (appropriately!)right

It is often cited as meaning that asset allocation accounts for the differences in the annual rates of return earned by pension funds, rather than the quarterly variations of returns. I must confess that in my book, Bogle on Mutual Funds, I made that error, saying that the allocation of assets among stocks, bonds, and cash “has accounted for an astonishing 94% of the differences in total returns achieved by institutionally managed pension funds.” Happily, I think I rectified that shorthand summary by coming up with the correct conclusion: “long-term fund investors might profit by concentrating more on the allocation of investments between stock and bond funds and less on the question of what particular stock and bond funds to hold.” I stand by that conclusion today.

That speech offers Ten Commandments to fund directors, along with a Golden Rule: Put fund shareholders first. It is as simple as that. I do not believe that there is sufficient awareness of that Golden Rule today, in part because independent directors have not fully measured up to their responsibility—codified in the 1940 Act—to place the interests of mutual fund shareholders ahead of the interests of mutual fund managers and distributors. I know that is a hard responsibility to fulfill, but I hope my reflections will help you fulfill it. Something fundamental has gone wrong with the mutual fund industry, and fund directors must assume their share of the responsibility.coming

“In an uncertain world, tactical change should be made sparingly, and only if you are prepared to take the risk of being wrong.” In my book, I presented a basic asset allocation model that recommended that older investors, no longer adding to their assets with additional investments and becoming increasingly dependent on income, should focus on a 50/50 stock/bond allocation, reduced to 35% for investors over the age of 75. (No, I’m not there yet, even using my non-heart-transplant age!) Both model portfolios recommended that the equity position be composed of value funds and equity-income funds, to the exclusion of growth funds, although I have not followed this strategy myself. Instead, I’ve relied largely on broad-based index funds which weight value and growth equally. In any event, both the 50/50 and 35/65 equity-income and value-based portfolios actually rose 14% during 2000 and are now actually up another two percentage points so far this year. (Both had about the same returns.) We should all have been so lucky! I have no way of knowing how many of you followed my conservative advice, nor how many of you, lured by the boxcar gains turned in by growth funds and tech funds as the stock market reached its high a year ago, abandoned it at just the wrong time. But I believe that if you were guided by the “Twelve Pillars of Wisdom” that was the epilogue of my first book, you’ve done just fine.

the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And this callow young kid had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these investment professionals would focus on enterprise. In what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Today, while the now-$12-trillion mutual fund industry holds some 35 percent of the shares of just about every public corporation in the land, the industry’s focus on speculation has actually increased many times over. Alas, the steady, sophisticated, enlightened, and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has failed abjectly to materialize. I was wrong. Call the score, Keynes 1, Bogle 0. What else is new?

Business Week described “a free-form financial corporation offering a complete line of financial services—worldwide. . . that may shake the entire industry.” The fledgling Institutional Investor magazine ran a cover story entitled “The Whiz Kids Take Over at Wellington.” We started off with a bang, and by the time 1967 was over, Ivest Fund was to have the best five- year record in the fund industry. But this was the “Go-Go Era” on Wall Street, which, as it turned out, was on the verge of collapse. What is more, the new investment group proved a painful disappointment. My determination to move quickly, my naiveté, and my eagerness to ignore the clear lessons of history had led me into a serious lapse of judgment. My error had resulted in failure—but just maybe reflected the attributes of a budding entrepreneur. In a sense, of course, life is often fair. I made a big error and I paid a high price. With the bust of the Go-Go Era in 1968, and then the terrible 1973-1974 bear market (down 50% from high to low; yes, it could happen again), the bloom was off the rose.had

Typically, the allocation might range from something as crude as, say, 50% in stocks and 50% in bonds for older, moderately risk-averse investors who have accumulated substantial capital, have reached normal retirement age, and need to draw down income. Or up to 100% stocks for young, confident investors who are just beginning to accumulate their first investments in a 401-K retirement plan, and have scores of years before drawing down income. In an uncertain world—and it will be ever thus—getting allocation almost right may be better than getting it precisely wrong. The fact is that we know little about the future returns that stocks and bonds will provide. But we must rely primarily on stocks for capital appreciation and on bonds for income, and we have to realize that stocks involve substantial risks. No matter what you read about historical returns of common stocks, I assure you that the stock market is not an actuarial table. But the common stock portion of your allocation provides the only sensible approach to building your capital over the long-term. So the question becomes: Which equity mutual funds will build your capital with the greatest effectiveness.Allocation

Brands,1 had Franklin possessed the soul of a true capitalist, “he would have devoted the time he saved from printing to making money somewhere else.” But he did not. For Franklin, the getting of money was always a means to an end, not the end in itself. “During the years when his (printing business) had to be established and placed on a sound footing,” Brands reports, “no one worked harder.” But the other enterprises he created as well as his inventions were designed for the public weal, not for personal profit. When he reminded us that “energy and persistence conquer all things,” Franklin was likely describing his own motivations to create and to succeed. Today, as we move into the twenty-first century, I’d like to talk to you about three areas in which Dr. Franklin’s idealistic eighteenth-century version of entrepreneurship should continue to inspire us. First, the application of his relentless energy and persistence to the service of the community’s greater good. Second, his invention—largely through trial and error and common 1 Benjamin Franklin—The First American, Doubleday, 2001.

Make no mistake: Business is an honorable career. Adam Smith told us why: “The pleasures of wealth and greatness strike the imagination as something grand and beautiful and noble, well worth the toil and anxiety . . . [they] keep in continual motion the industry of mankind, to build houses; to found cities and commonwealths, to invent and improve all the sciences and arts, which enoble and embellish human life; which have entirely changed the whole face of the globe, and [have paved] the great high road of communication to the different nations of the earth.” He wrote those words 230 years ago. Could it be better said today? Yet as I survey America at the millennium, I see our nation’s business values eroding. Yes, I see marvelous entrepreneurship, brilliant technology, and creativity beyond imagination. But I see far too much greed, materialism, and waste to please my critical eye. I also see an economy too focused on the “haves” and not focused enough on the “have-nots,” underinvesting in education, especially among those who need it most, not merely to prosper, but to survive. I see shocking misuse of the world’s natural resources, as if they were ours to waste, rather than ours to preserve as a sacred trust for future generations, and I see a political system corrupted by a staggering infusion of money that is, I assure you, rarely given by disinterested corporations that expect no return on their investment. Markets and Economics But I also see hope.

you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but in my new book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in that system. There is much that needs to be fixed, for “the business and ethical standards of corporate America, of investment America, and of mutual fund America (the three principal elements of the book) have been gravely compromised.” In each of these three arenas, I discuss not only what went wrong, but why it went wrong, and how to go about fixing it. Right at the outset I warn the reader that mine is a tough message, bluntly delivered, opening with this epigram from St. Paul: “If the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?” In this case, the battle is for the soul of our capitalistic system. Today’s Capitalism So my trumpet, as you’ll now hear is a certain one. Today’s capitalism has departed, not just in degree but in kind, from its proud traditional roots, a system that served us admittedly imperfectly, but with remarkable effectiveness for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work.

This is not to say that the history of capitalism is without blemishes, and profoundly serious ones at that. Among its moral failings are the early abuse of child labor, and the continuing misuse of natural resources, the lack of adequate concern about our society and the environment, and its growing role on political campaign contributions in shaping vital national issues. But in the recent era, one of the main failings of capitalism is as a system of corporate ownership. It has departed, not just in degree but in kind, from its proud traditional roots, a system that served us, despite its imperfections, with remarkable effectiveness for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work. And then, as I write in Battle, “Something went profoundly wrong, fundamentally and pervasively, in corporate America. At the root of the problem, in the broadest sense, was the societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.’ We had become what Campbell called a ‘bottom-line society.

And then, late in the twentieth century, something went wrong, a “pathological mutation in capitalism,” in the words of journalist William Pfaff. The classic system—owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners in maximizing the return on their capital investment. But a new system developed—managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” And so it is. Once an “ownership society” in which direct owners of stock held voting control over corporate America, we have become an “agency society,” and we are not going back.first

’ But at least in my view, our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” It’s all too easy for you in our younger generation to look at capitalism as a money- grubbing system in which greedy businessmen, investment bankers, and money managers of hedge funds and mutual funds alike garner unfathomable wealth at the expense of the average citizen who does the nation’s work and does it with neither complaint nor the hope of outsized rewards. And while there is some truth to that—indeed, in the book I express great concern about a two-tier society divided (and hardly evenly) between “haves” and “have nots”—let us not forget that it was the flourishing of true capitalism two centuries ago that has been importantly responsible for the plenty we enjoy in the modern era.

Make no mistake about it, then: It was speculative return that drove the Great Bull Market. The fact is that, based solely on investment return, $1 invested in the S&P 500 at the outset would have grown to $7—a handsome seven-fold enhancement. But the leap in the P/E multiple alone increased that investment return to a market return of $24—nearly twenty-four times over, 3½ times (!) the hardly inconsequential investment gain. Yes, we had literally never had it so good. Can it happen again? I can’t imagine how. To understand why, let’s take Lord Keynes’ advice and look at the sources of the past returns on stocks and then apply them to the decade ahead. Today, the S&P 500 Index yields not 5% but 1½%, reducing this key contributor to stock returns by fully 3½ percentage points. When we add an assumed 6% earnings growth (corporate earnings, truth told, grow at about the same pace as our economy), the investment return on stocks would be just 7½% per year. Will speculative return add to or detract from this figure?earnings

I was recently asked about this issue in a question I received from a Vanguard shareholder, a member of a sort of Internet fan club known as “the Bogleheads.” (It is true!): Do you find that when people donate their money or volunteer their time to those less fortunate, good comes their way? And when people are miserly with their money and not very charitable with their time, do the chickens come home to roost? My response: Much as I’d like to shout amen to that thought, I fear that the rewards for doing right and the retaliation for doing wrong are rarely found—at least in any systematic or causal way—here on earth. We’ll have to receive the rewards in Heaven, if we are too receive them at all. The act of giving should itself be the motive for the deed. And when you give, give with an open hand.modest

at that), that’s still quite high relative to the long-term norm of 16 times. So, I think the P/E is unlikely to rise, and could easily decline, perhaps to 18 to 20 times. No one—no one—can be confident about how much investors will pay for a dollar of earnings ten years hence. But if my expectation is reasonable, the resultant easing of the P/E from current levels would create a negative speculative return of about 1% per year, reducing the annual return on stocks to about 6½%. I’m not much for such precision, however, so let’s assume a wide range of returns on stocks in the years ahead, say 4% to 9%. In any event, we’d best all count on a coming era of lower returns in the stock market, and then hope we’re wrong. But I hardly need remind you: Relying on hope is not a sensible investment strategy. What About Bonds? How will these returns compare with those of other financial assets? Bonds are the customary alternative to stocks, and expectations for bond returns over the coming decade are reasonably easy to establish. Again, Keynes’ analysis helps us here, for the investment return on bonds—“forecasting the prospective yield of assets over their whole life”—depends largely on the interest payments they generate. And since bonds have a fixed maturity date, speculative return plays little role over the long- run. Result: A remarkably high proportion of the subsequent ten-year investment return of bonds is explained simply by the current yield.

“A Pathological Mutation” But something has gone wrong in the capitalist system itself. It is well-described by journalist William Pfaff as a “pathological mutation” from the classic system, owners’ capitalism—based on a dedication to serving the interests of the corporation’s owners in maximizing the return on their capital investment—to a new system, managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” And so it is. Once an “ownership society” in which direct owners of stock held voting control over corporate America, we have become an “agency society,” and we are not going back. For direct ownership has largely given way to ownership by financial institutions, mainly mutual funds and pension funds. While these institutions held only 8 percent of all U.S. stock a half-century ago, today they own some 70 percent—absolute control of corporate America.

Nor that dividends were lowered in order to provide more capital for unwise expansion. Nor that the estimated future returns of 9% to 10% or more on the company’s pension fund were, simply put, “pie in the sky.” Nor could directors possibly have been unaware that it was management that hired the consultants who recommended to the compensation committee higher compensation for that very same management, year after year, even for so-so accomplishments—or worse—in building the business. Nor that shares acquired by executives through stock options were sold as soon as they vested. Nor that the company’s accounting firm was receiving consulting fees many times the amount of its auditing fees, substantially vitiating both its independence and its integrity. And all those director “nor that’s” describe only the major aberrations in the barrel of capitalism. Surely it is fair to say that it is our corporate directors who should bear the ultimate responsibility for what went wrong with capitalism in corporate America. Oh, No They Shouldn’t!

” While all of this gratuitous advice from a callow college senior was, alas, largely ignored by the fund industry, the creation of Vanguard as a truly mutual mutual fund group—operated on an “at-cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I talked the talk about all those years ago. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, and not only my Battle book, but in my new book, The Little Book of Common Sense Investing, both of which express—in different ways—my concern about our business and finance system, where so much has gone wrong. It is truly astonishing how pervasive have been the failures in our capitalistic system. While it’s often alleged that these problems have been limited to just “a few bad apples,” the evidence suggests that the barrel that holds all those apples, good and bad alike, has developed some serious problems. For example:  Yes, there have been “only” a few Enrons, WorldComs, Adelphias, and Tycos. But during the past five years, there have been 5,989 restatements of earnings by publicly- held corporations, with stock market capitalizations aggregating more than $4 trillion, often reflecting overly aggressive accounting procedures.Motors)

The Mutual Fund Industry—Meeting Investor Needs? My outlook for financial market returns suggests that the long and exciting voyage of the stock market is unlikely to get less adventurous. We not only live in a risky era, but an era in which lower returns in the financial markets, across the board, seem the order of the day. But please don’t make the mistake of assuming that those are the returns investors will actually receive. The fact is that few investors indeed ever have received—or ever will receive—the returns that the markets provide. This brings me to yet something else we know: Since all investors as a group garner the gross returns of the market, beating the financial markets is a zero sum game. And since investing costs money—lots of it!—all investors as a group lose to the markets by the exact amount of their costs, and beating the markets quickly becomes a loser’s game. Because of the staggering costs imposed by financial intermediaries, the lag in investor returns is substantial. Consider the mutual fund industry. Fund advisory fees and operating expenses this year will come to about $70 billion; sales charges and out-of-pocket costs, another $5 billion; the hidden—but real—costs of portfolio turnover, another $35 billion. Total $110 billion. What is more, despite the industry’s staggering growth, these costs have soared even faster, for only a tiny portion of the huge economies of scale involved in fund operations have been shared with investors.

The biggest risk is the long-term risk of not putting your money to work at a generous return, not the short term--but nonetheless real--risk of price volatility. Even though stocks seem very high, consider what I said in my book “never think you know more than the market does.” You’re apt to be wrong. Second, give yourself all the time you can. At the extremes, if you’re in your twenties, begin to invest in stocks even if you only have a small amount to invest; if you’re in your sixties, invest more in bonds and less in stocks. Compound interest is a miracle, and time is your friend.market

18% for stocks, but perhaps 4% to 8%. Not 10% for bonds, but perhaps 5% to 7%. Not 7% for the money markets, but perhaps 3% or 4%. Maybe we’ll be surprised on the upside. I hope so! Taking the Toll 1: Fund Costs But whatever the returns in those markets turn out to be, the returns of comparable mutual funds will be significantly lower. The reason for the lag, of course, is costs. And we know pretty much what those costs are: management fees, operating expenses, sales charges, portfolio turnover costs, out-of-pocket fees, and cash drag. (Most stock and bond funds hold a small percentage of their assets in cash.) All-in costs for the average stock fund come to something like 2½% per year; for the average bond fund, 1 1/3%; for the average money market fund, 7/10 of 1%. In the new era I foresee (I hope I’m wrong!), equity fund costs would consume between 30% and 60% of stock market returns. Bond fund costs would consume from 20% to 25% of bond market returns. And money fund costs would consume about 25% of money market returns. Taking The Toll 2: Market Timing Further, while the average equity fund provided returns of 15% during the great bull market, please don’t make the mistake of thinking that the average equity fund investor earned 15%. No, recent data suggest that such an investor earned about 6%. Just 6%! Less than regularly rolling over a bank three-year certificate of deposit during the two decades. How can that possibly be? The answers are not very complicated.

Morgan’s Wellington Fund—and my career in the financial markets began. It would be, well, fatuous to think that I’ve left our nation’s markets in better shape than when I first found them way back in 1949. It would also be wrong. For institutional investing has moved from an earlier era focused on the professional standards of trusteeship to a new era of asset gathering and salesmanship, from management to marketing, from the wisdom of long-term investing to the folly of short- term speculation, and from being owners of stocks to renters. (Turnover of shares in the stock market was about 25 percent in the 1950s and 1960s; today it is 150 percent—six times as high.) These changes have ill-served investors. So in my speeches across the land, and especially in my most recent two books (The Battle for the Soul of Capitalism, and The Little Book of Common Sense Investing), I’m shamelessly campaigning to return capitalism and the financial markets to the values that made them such priceless national assets in an earlier age. Only if we return our economic system to its proud roots, and focus on long-term investing rather than short-term speculation will the job of capitalism be well done. Emboldened by the fine reviews of The Little Book in Sunday’s New York Times, in Monday’s USA Today, and in today’s Wall Street Journal, I’m encouraged that the message is finally beginning to gain traction.

Exhibit VI: Percentage of Risk Premium Consumed by Expenses Fund Expense Equity Risk Premium Group Ratio 2% 3% 4% Lowest Cost 0.2% 10% 7% 5% Average Cost 1.5 75 50 38 Highest Quartile 2.2 110 73 55 Looking out over time, from the price levels in today’s market, a 2% risk premium might be a reasonable guess for the coming decade. Indeed, many respected investment advisers might place the probable number at less than 2%. Well, I’m often wrong (seldom in doubt), so first let’s explore what a normal equity premium might be. I went to the acknowledged authority on the subject, best-selling author (Stocks for the Long Run) and Wharton School Professor Jeremy J. Siegel. He obligingly sent me a two-century history of equity premiums on U.S. stocks over long-term U.S. Treasury bonds. It is reproduced in the chart below. The average equity premium over this long, long period is 3.5%. I will leave it to you to decide what is a fair number to use today, but, for the rest of my analysis, I’m going to rely on this average. So, let’s imagine you are an investor confronting the real world of mutual funds today, and examine what happens when you

A Failure of Character But there’s more at stake than that. This nation’s founding fathers believed in high principles, in a moral society, and in the virtuous conduct of our affairs. Those beliefs shaped the very character of our nation. If character counts—and, as my book underscores, I have absolutely no doubt that character does count—the failings of today’s business and financial model, the willingness of those of us in the field of wealth management to accept practices that we know are wrong, the conformity that keeps us silent, the selfishness that lets greed overwhelm reason, all erode the character we’ll require in the years ahead, especially in the post-September 11 era. The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as “something grand and beautiful and noble, well worth the toil and anxiety.” I can’t imagine that anyone in this room today would use those words to describe our corporate governance system at the outset of the 21st century. So, yes, too many of our corporate stewards have failed to earn our faith. By focusing on short-term speculation at the expense of long-term investing, we institutional managers have, I fear, gotten the corporate governance that we deserve. Yet most giant institutional investors have been conspicuous only by their silence.

but also both its management company’s propensity to move managers around, sometimes seemingly at the drop of a hat. Turnover costs can cut your long-term returns by a meaningful amount, so do your best to find funds both with portfolio holdings and portfolio managers that will stay the course. 3. Realize that Taxes are Fund Costs, Too There is yet a third croupier in the fund casino. And in this bull market era, it happens to be the greediest croupier of them all: The Federal Government. Make no mistake about it, Uncle Sam loves the mutual fund industry. For as impatient, aggressive fund managers buy and sell stocks at a furious rate, they pay virtually no attention whatsoever to the taxes such activity will require you to pay. They can ignore taxes, but you can’t. There is awesome value in deferring taxes—and deferring them for as long as you can. When you pay taxes today, that money can’t compound to your benefit tomorrow. Deferring a capital gain for 15 years reduces the present value of each one dollar of taxes to just 41 cents; in 25 years, to 23 cents. Yet fund managers not only require you to pay the 20% tax far too early, realizing long-term capital gains far too prematurely. They also have been realizing some one-third of all capital gains on a short- term basis, thus forcing you to pay taxes at rates up to the 40% maximum on dividend income.

Taking The Toll 3: Fund Selection And investors are also hurt in another perverse way. They have a deep-seated tendency to buy on the basis of past performance, pouring their money into exactly the wrong funds at precisely the wrong time. For example, during the twelve months ended March 2000, when the great technology-age market bubble was inflating to its very bursting point, investors poured $240 billion dollars in technology funds and tech-oriented growth funds at their peak levels, funding some of those purchases by actually withdrawing $40 billion from the value funds that had failed to participate in the great boom. In the aftermath, the asset values of the most popular growth funds declined by an average of 63% from high to low, while the most unpopular value funds actually rose in value by 3%. Combined with the toll taken by fund costs and the toll taken by market timing, this penalty for adverse selection is the third leg of the unfortunate triumvirate of tolls that has left mutual fund investors in the backwater of the returns earned by the financial markets. If financial advisors do no more than keep your client from paying these unnecessary tolls, you’ve made a great start on serving them well! Of course, stock market booms and speculative manias are merely a reflection of the public mood. Tuplipmania, the South Seas Bubble, the Crash of 1929, it is often argued “just happen.

developing quantitative approaches—Enhanced Indexing and Positive Alpha—represent important challenges to the status quo. The Changing Role of the Traditional Active Manager Faced with this competition, how should the traditional manager respond? If closet indexing is the wrong response, indeed a counterproductive one—as I believe it is—what is the right one? First, a given: today and for as far ahead as the eye can see, each adviser should freely acknowledge that he or she should be expected to outpace an agreed-upon market performance standard over the long run, and strive to do just that. What else is an adviser supposed to do? How else can we measure whether any economic value being created is sufficient to justify the cost of retaining the adviser in the first place? Of course, the standard need not necessarily be the S&P 500 Index (though it would be appropriate for large cap funds with a blended—growth stocks and value stocks—style). Broader all-market indexes will also become part of the world of investing. And other styles may also be considered as standards. Indexes measuring returns for style/market cap “boxes” (nine, under the Morningstar system) will also become part of our world. It is simply unrealistic for small-cap managers, or mid-cap managers (or for that matter high-cost large-cap managers, though they have the best chance) to duplicate the long-term record of an all-market index.

owning the market through a low-cost index fund, we know next to nothing about the records of SMA Managers.  Fourth, the challenges of operating SMAs is substantial. Few registered advisers and brokers are satisfied with today’s (largely) APL technology. And while tomorrow’s technology will surely be better, it’s hard to imagine that it can ever be as economical as the simple pooling of accounts that has been the crux of mutual fund operational efficiency since the industry began. A New Mutual Fund Industry Nevertheless, if mutual funds fail to change, our dominance will come to an end. We hold no permanent monopoly on the good will of our owners; we must re-earn it every day. Fund managements can no longer bask in the warm noonday sun and continue to place their own needs ahead of the needs of their clients. During the great bull market, many firms that trod the wrong path prospered. Even where prudence, principles, and stewardship took a back seat to marketing, the money rolled in. Hundreds of new aggressive funds were formed and backed with more than a billion dollars of advertising. “We’ll focus on short-term rewards, momentum, and concept stocks,” was the implicit strategy, “and don’t worry about higher fees, and portfolio transaction costs.” In an era of exploding returns on stocks, the sky seemed to be the only limit to excess. Those strategies won’t play well in the years ahead. We must make speculation passé, and put stewardship in the driver’s seat.

compared to $14 million for the average managed mutual fund, as chance would have it, the very same nine million dollar increment reflected in my statistical study of a quarter-century earlier. III. Virtue It turns out that entrepreneurship, mutuality, and invention have something in common: Virtue. While virtue is a word that tends to embarrass us today, it surely didn’t embarrass Dr. Franklin. In 1728 when he was but 22 years of age, he tells us that he, “conceived the bold and arduous project of arriving at moral perfection . . . I knew, or thought I knew, what was right and wrong, and I did not see why I might not always do the one or avoid the other.” The task, he tells us, was more difficult than he imagined, but he ultimately listed thirteen virtues along with their precepts, even placing them in rank order of importance. The first four were Temperance, Silence (“Speak not but what may benefit others or yourself”), Order, and Resolution (“Perform what you ought”). The next were Frugality, Industry (“Be always employ’d in something useful”), Sincerity, and Justice. Then Moderation (“Avoid extreams”), Cleanliness, and Tranquility (“Be not disturbed at trifles”). And finally Chastity (though here Franklin famously succumbed to temptation) and Humility (“Imitate Jesus and Socrates”).

Reasonable as these ranges seem to me—though they are in no way assured—I just can’t imagine deciding to go with that particular growth fund simply by reason of its putative superior future return under these tenuous assumptions. In all, I believe much of our industry’s information technology is presenting investors with hypothetical information clothed in the mantle of precision. Long-term investors, I think, would be far better served to simply stop trying to outguess the unguessable, and opt for using a simple asset allocation plan, not a complex one: owning the entire stock market, not trying to select winning stock funds based on their past returns. Sometimes it is better to be roughly right than precisely wrong.and

they expect to call on, say, 30 years hence? Wouldn’t they be as well served—or better served— by buying right, holding tight, and checking on their account once a year or so? That kind of discipline will pay off in the long run. Knowledge may be power, but the fact that fund investors are receiving better information than ever before has been largely offset by their using that information for the wrong purposes. The bandwidth of the human mind, I fear, has been overwhelmed by the staggering bandwidth of information now presented to us—even thrust on us. What should make fund investing better may well be making it worse. The trick is to convey the vast array of information available to fund investors in a sensible but focused way, so as to provide perspective—not merely on a one-way information highway, but through a two-way communication network. (4) Better Communications with Owners? To better communicate with our Vanguard shareholders, in recent years we have begun to use technology to enhance the services we provide. Today, fully one-third of our individual assets are held by shareholders registered on our website. And nearly 50% of our client service interactions take place over the web. Our goal is to give our clients the closest thing to personal service that is possible without actual face-to-face, person-to-person interaction, which, truth told is, as a practical matter, impossible.

earlier chart on style diversification showed, that was exactly the period when investors should have been moving out of growth and technology funds and into value funds. What folly! When it jumps on the bandwagon of past performance, the crowd is always wrong. Pillar 9. You May Have a Stable Principal Value or a Stable Income Stream, But You May Not Have Both. Contrast a money market fund—with its volatile income stream and fixed value— and a long-term government bond fund—with its relatively fixed income stream and extraordinarily volatile market value. Intelligent investing involves choices, compromises, and trade-offs, and your own financial position should determine the most suitable combination for your portfolio.2 As 1991 began, the yield of the average money market mutual fund was just under 6%, and the yield on a long-term U.S. Treasury bond fund was just over 7½%. During the ensuing decade, the value of a $1,000 investment in the money market fund never varied, while $100 invested the bond fund fell to as low as $93 (in 1992) and rose to as high as $123 in 1998. Stable principal vs. variable principal. But the annual income on the $100 money market fund investment was not to approach $6 again until 2000. Indeed, with declining interest rates, annual income is now on the way to the $4 level. The annual income stream on the $100 initial investment in the long-term bond fund, on 2 In my book, I compared a 90-day U.S. Treasury bill with a 30-year Treasury bond. $1.

Who Earns the Market Returns? But whatever returns the financial markets are generous enough to deliver, please don't make the mistake of thinking investors actually earn those returns. To explain why this is the case we need only to understand the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs of investing are deducted. After all the costs of financial intermediation are deducted—all of the management fees, the transaction costs, the distribution costs, the marketing costs, the operating costs, and the hidden costs of financial intermediation— the returns of investors must—and will, and do—fall short of the market return by an amount precisely equal to the aggregate amount of those costs. Result: Beating the market before costs is a zero-sum game; beating the market after costs is a loser's game. The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. The great paradox of investing is that you don't get what you pay for. The fact is quite the opposite: You get what you don't pay for. Consider the costs of equity mutual funds. Management fees and operating expenses—the "expense ratio"—average about 1.6% per year of fund assets.

When managers of traditional active equity funds claim to have a way of uncovering extra value in our highly- (but not perfectly-) efficient U.S. stock market, investors will look at their past record, consider the manager’s strategies, and then invest or not. These new index managers are in fact active managers. But they not only claim prescience, but a prescience that gives them confidence that most sectors of the market (such as dividend-paying stocks) will remain undervalued for as far ahead as the eye can see. But, if these factors are underpriced, why won’t investors, hungry to capitalize on that apparent past inefficiency, bid up prices until the undervaluation no longer remains? Put another way, if these promoters of the purported new paradigms actually have been right in the past, won’t they therefore be wrong in the future? Interestingly, the choice of the ETF structure—rather than the standard mutual fund format—by these confident entrepreneurs would seem to belie the fact that their “fundamental indexing” approach may take decades to prove itself, if indeed it does so at all. Because by choosing the ETF format, they imply even more strongly that investors who actively buy and sell their new fundamental funds will lead to even larger short-term profits than buying and holding them for the long term. I recommend skepticism about these purported “new paradigms.” I’ve witnessed too many new paradigms over the years. None has persisted.

Indeed, while investment costs of 3% during 1984-2000 (with average fund costs at higher levels than in the 1950s, ‘60s, and ‘70s) reduced the stock market return of 16% for that period to 13% for the average fund, the average fund investor earned just 5%. How was that shortfall possible? First, because investors were victimized by unfortunate market timing, making modest purchases of equity fund shares when stock prices were cheap during the early years of the period and then making huge purchases when prices were dear as the bubble inflated during the later years. Second, because of adverse fund selection, as investors poured their savings into technology funds and tech-oriented growth funds and pulled them out of value funds at precisely the wrong time, with most of their dollars goings into existing funds with the hottest records of performance and new funds that promised full participation in the “exciting Information Age” that supposedly was before us. To regain the faith of equity investors, the mutual fund industry must face up to the obvious issue of excessive costs.tumble

For exceptional funds with exceptional past returns that are substantially superior to the market will regress toward, and usually below, the market in the future. Regression to the mean-I call it the law of gravity in the financial markets-is measurable and apparently almost inevitable. For example, in two studies of returns over consecutive decades, a remarkable 99% of top quartile funds moved closer to-and even below-the market mean from the first lO-year period to the subsequent 10-year period. There was only one single, solitary exception to the rule, a fund that ruled the world during the 1970s and 1980s alike. But so far in the 1990s, it has regressed magnificently, falling far below the market's return. Sometimes mean reversion requires patience! Make no mistake about it: the record is clear that top performing funds inevitably lose their edge. This industry is well aware of that certainty.most

Only a few weeks ago, for example, the Securities and Exchange Commission censured and fined one fund manager for reporting misleading returns, warning that, “it is wrong to raise shareholder expectations of future gains by advertising future returns when it is highly unlikely those returns can be sustained.” Yet on our television sets and in our newspapers, everyday, we see fund managers hawking past fund records that cannot possibly be sustained. Don’t let yourself be influenced by such advertising.

Wrapping Up It was Bernard of Chartres who said in the twelfth century that a dwarf standing on the shoulders of a giant may see further than the giant himself.3 And so this plain-thinking, common- sense-reliant mutual fund veteran stood on the shoulders of Lord Keynes and Professor Samuelson in his efforts to cut through the fog surrounding the foxes of Wall Street and focus on the great idea of the hedgehog. The clear message: history often teaches us the wrong lessons about the financial markets. The past, truth told, is rarely prologue to what lies ahead. The real lessons of sound investment strategy depend upon focusing on the sources of stock and bond returns, and minimizing to the nth degree the costs extracted by our bloated investment system. So, my fellow members of The American Philosophical Society, you thoughtful and intelligent movers and shakers of American thought, please think about the implications of indexing for the financial markets in the years ahead. And while you’re about it, consider whether you should rely importantly on indexing in your own investment programs. That’s important too! 3 Perhaps this idea was the inspiration for the acknowledgement by Sir Isaac Newton in 1676 that “If I have seen further, it is by standing on the shoulders of giants.”

The Penalties of Timing and Selection First, consider the timing penalty. With the Standard and Poor's 500 Index languishing under the 300 level during 1984–1992, investors purchased equity funds at a $10 billion annual rate. But with the index over 1100 in 1999, on the way to its 1527 high in 2000, investors poured money in at a $220 billion annual pace. Putting so little of their money into equity funds in the early years when stocks were cheap, and so much of their money when stocks were dear, has cost fund investors plenty, and the fund industry must share the responsibility for that counterproductive pattern. Chart: The Timing Penalty Investors also paid a huge selection penalty, and here the industry's responsibility is far greater. During the bubble, we created and promoted growth funds and sector funds that favored over-priced NASDAQ stocks—the "new economy," technology, and the internet. At precisely the wrong time, investors poured $460 billion into these highly risky funds and withdrew nearly $100 billion from the conservative value funds favoring NYSE stocks—"old economy" stocks which, bless them, both lagged the market as the bubble inflated and held fairly steady as it burst. Chart: The Selection Penalty The net result of cost-induced performance lag of the average fund, leveraged by the timing penalty and the selection penalty paid by the average fund investor, is truly stunning.

The Vanguard funds also voted against auditors at 21% of the firms, and against 64% of stock option plans. I believe that active voting policies by mutual funds will become more evident with each passing year. Once owners become used to acting like owners, once corporate citizens understand their rights and responsibilities in a democracy, once institutions begin to cooperate with their peers for the common good, we can at last begin the process of replacing Managers Capitalism with Owners Capitalism. Some Mind-Expanding Wisdom But there is more that needs to be done. And some important ideas about radical reform have been put forth by Robert A.G. Monks. Few individuals have been as deeply involved in corporate governance issues—and even fewer have played as constructive a leadership role—as Mr. Monks, founder of ISS as well as the corporate activist firms Lens, Inc., and Lens Governance Advisors. His fact-filled 564-page tome Corporate Governance (with Nell Minow) is a must-read for those who seek to understand what went wrong in corporate America and what needs to be done.Maker’s

successful (past) performers. Such a strategy defies all reason except for this one: promotion of such funds brings in lots of new money, and lots of new fees to the adviser. But such promotions, finally, lead investors in precisely the wrong direction. Ignore them. So, be sure to disregard "lump sum" performance comparisons. But follow the next rule. Rule 4. Performance to Determine Consistency and Risk. Studying the nature of past returns enables you to determine consistency. Look at a fund's ranking among peer funds with similar policies and objectives (i.e., a large cap value fund with other large cap value funds, a small cap growth fund with other small cap growth funds, and so on). Morningstar makes this easy. It shows, in a simple chart, whether a fund was in the first, second, third, and fourth quartile of its group during each of the past 12 years. For a fund to earn a top performance rating means, in my mind, at least six to nine years in the top two quartiles and no more than one or two in the bottom quartile. This information-shown in this example of two real-world funds that reflect the standards I've set forth-is ignored by too many investors. CHART 19 The "good" fund is in the top half in 10 years, in the bottom quartile but once. The 'bad" fund is in the top half six times, (all in the early years-a significant factor) but in the bottom quartile four.

D; intelligent selection of funds for future performance, D; investment behavior of shareholders, F.  Transaction technology: Ease and facility, A+, implicit encouragement to trade funds, A+; efficiency and expense savings, A+; flow-through of lowered costs to fund shareholders, F; facilitation of enhanced shareholder returns, F. My report card would rate the contribution of technology to information as A+; to knowledge, C; and to wisdom, D or perhaps even F. In all, good grades go to the technology, bad grades to the users. What does the technology revolution portend for tomorrow? More Websites, more bulletin boards. More information, more transactions, still more facilitation and speed, and more cost savings (though probably not flowed through to the benefit of fund shareholders). And, I must add, more risk. Most of the new financial instruments made possible by the computer power of technology have never been tested in the crucible of a bear market. Nor have most fund shareholders, who are now able to trade without restraint. And, given the Internet, they can do so without even the intercession that used to be represented—for better or worse—by the inability of funds to staff enough telephone lines. Anyone who is not cognizant of these risks is, in my view, making a serious mistake. But I am not an aging Luddite who is renouncing the future and calling for a return to the past. We can’t go home again.

participation, not only in the giant cap stocks of the S&P 500, but also in the small-cap and mid-cap segments of the market. (While I see no compelling reason to include international equities in your program, I would note that they can be successfully indexed too.) The index fund is the ultimate response to the power of RTM in the selection of mutual funds. It avoids “the loser’s game” of selecting individual funds based on past performance that overpoweringly reverts to a mean that persistently falls short of the market return. Rare indeed is the serious study that suggests that it is possible to select significant winners in advance. Indeed, I accept the general notion of RTM among market segments such as growth stocks versus value stocks and U.S. stocks versus international stocks. But even if you believe that the clear lessons of history are pointing us in the wrong direction—always a risky bet—there would remain the equally risky bet of determining just which of the countervailing segments will in fact prove to be superior. If, for example, large cap and small cap stocks do not each revert to the market mean over the next 10 to 20 years, which of the two is the more likely to provide the superior return? Indeed, it is the extraordinarily broad diversification—the total, absolutely complete, diversity—of the total stock market index fund that commends it to investors. But only if that diversity comes with minimal cost.

But there's even more at stake than improving the practices of governance and investing. We must also establish a higher set of principles. Our founding fathers believed in high moral standards, in a just society, and in the virtuous conduct of our affairs. Those beliefs shaped the very character of our nation. If character counts—and I have absolutely no doubt that character does count— the ethical failings of today's business and financial model; the manipulation of financial statements; the willingness of those of us in the field of investment management to accept practices that we know are wrong, the conformity that keeps us silent, the selfishness that lets our greed overwhelm our reason; all have eroded the character of capitalism. Yet character is what we'll need most in the coming new era I've described today; more than ever in the wake of the great bear market and the investor disenchantment it reflects; more than ever in these days when economies around the globe are struggling to find their bearings; more than ever in the strife-ridden world around us, where America's strength lies more than ever in her values, her ideals, her goodness. The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as "something grand and beautiful and noble, well worth the toil and anxiety."

and our Total Stock Market Fund (3%!) and you’ll clearly see what a difference a benchmark makes. Tax impacts too have been nicely constrained. But if our shareholders move their money around rapidly in less generous markets than these, or heavily withdraw substantial assets in a bear market, the roadblocks to maintaining that excellence will be formidable. Nonetheless, I have not lost all hope for the market-segment index fund, for most of these problems could be solved by the creation of better market-segment indexes—indexes with new definitional concepts that offer less sensitivity to stock substitutions, and therefore lower portfolio turnover—and the imposition of redemption fees to reduce short-term trading in these funds. For those investors who cannot resist the urge—which they probably should resist!—to overweight or underweight one market segment or another, such funds may well provide the most sensible approach. In any event, indexing of all types continues to grow. But much of the growth is coming, not through conventional index funds, but through novel index funds known as ETFs (exchange- traded funds), an acronym that trips from the tongues of almost every industry maven worth his or her reportorial salt, if only of a small subset of market speculators. The assets of these funds, I read in The New York Times last Sunday, totaled $53 billion at mid-year, and they are aggressively promoted. But—make no mistake about it—few of their holders are long-term investors.

At just the wrong time, shareholders had $16 billion invested in the growth index, but only $3½ billion invested in the value index— all too similar to the trends among actively managed growth and value funds. While segment indexing has provided good relative returns, I am confident it can provide even better returns if we design improved indexes, better risk disclosure, and perhaps redemption fees to deter short-term investors. I assure you that I will be thinking long and hard about how to create better segment indexes, and how to avoid their counterproductive use as trading vehicles rather than as investment vehicles. I hope you will do the same.Funds

7%, and 13%, respectively.) But today money market instruments yield about 2½%—not 6%— and bonds less than 6%—not 9%—so the handwriting is on the wall. In stocks, of course, the handwriting on the wall is harder to read, but the math is less than mysterious. Stocks are likely to provide earnings growth that will parallel the growth of our economy, most likely—but never certainly—6% in nominal terms. Add to that figure the current dividend yield—a measly 1½%—and the future investment return on stocks would average 7½% per year. Speculative return—whether investors will pay more or less for $1 of earnings (i.e., the price-earnings ratio)—may increase or reduce that total. But with stocks selling at a (normalized) 22 times earnings today, I believe the P/E is more likely to go down than up. A drop to 18 to 20 times, for example, would reduce the investment return over the next decade by one or two percentage points, taking the market return to 6½% or even 5½%. (If the P/E rises—unlikely in my view—the return could be 8½% or 9½%). If that tentative range seems wrong to you, you can use my simple methodology to calculate future stock returns for yourself. Just insert your own idea of earnings growth, and of the P/E ratio in 2011. But don’t get carried away! And always hold some stocks, for no one, least of all I, can predict future returns with accuracy. And now to the don’ts. First, don’t use those mathematics to predict the future of technology stocks.

past doesn’t require that you be wrong forever. Start today to alter your portfolio gradually. Begin with 25% of your equity holdings, and over, say, the next year or two, make the full conversion of your individual holdings to whatever index-based asset allocation fits your circumstances. Then, when you complete your program, get investing as far out of your mind as you can. Look at your portfolio no more often than once a year, but don’t change it, except to reduce the stock allocation a bit every five years or so. I can’t predict how much you will have in your account when you reach retirement, but I can predict—with as much certainty as is possible in the uncertain world in which we live—that it will be, not only considerably larger than the account of anyone you know who has put the same amount of money to work in a different fashion, but far less time-consuming and worrisome. Yes, you will be one of those fortunate souls who has been well served by this industry, and you will look at the wealth you have accumulated with a smile on your face. So, just go out and do it. And while you’re about it, if you work in the mutual fund industry, use your knowledge and your common sense to help us make the marriage between technology and mutual funds better, not worse, so that fund investors will be richer, not poorer in the years ahead.

Few, if any, industry leaders contemplated this outcome. They were bound by “presentism.” In a recent issue of The New Yorker, essayist Adam Gopnik tells us that, “of all our prejudices, the strongest is presentism . . . the assumption that what is happening now is going to keep on happening, without anything happening to stop it.” Surely that assumption was held by mutual fund industry leaders (except Jon Lovelace!), who paid no attention to this new fund complex with its new name and a new structure, at once both ridiculous and logical. These leaders tacitly assumed that the existing fund framework would keep on happening. That was a big mistake. The industry thought that a truly mutual structure was not even worth acknowledging. Even 43 years later, it has yet to be copied. And our peers snickered at the index investment strategy that the mutual structure facilitated, even demanded. One leader said, “The great mass of investors aren’t going to be satisfied with average returns. The name of the game is to be the best.” Another asked, “Who wants to be operated on by an average surgeon?” And a popular poster on Wall Street declared, “Help Stamp Out Index Funds! Index Funds are Un-American.” The indexing idea was so absurd that it took until 1988— 13 years later—before the first (and pretty much the last) of the industry’s “Old Guard” reluctantly joined the embryonic index fund movement. III.

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

merger brought us into the pension fund management business, which I thought would be a natural extension of the talents of our new management team’s mutual fund activities. So, I honored my fiduciary duty to the owners of Wellington Management Company—Mr. Morgan and its public shareholders. The firm had “gone public” in 1960, joining the parade of fund managers who poured through the gates opened by the ISI case. But I also believed that I had honored my separate and distinct fiduciary duty to the shareholders of Wellington Fund, for I expected that our new managers would apply their investment talents to enhancing the fund’s faltering returns . . . Wrong! Wrong! Wrong! Looking back, the merger was an abject failure—perhaps the worst merger ever, although AOL/Time Warner sets a high standard indeed. Though the “new era” finally ended, in this case, as 1973 began. Then, Wellington Fund had reached the most aggressive allocation to equities in its near-half-century history (82%, often of marginal investment quality). Its returns tumbled, and its reputation plummeted. Every one of our equity and balanced funds—including several new ones— failed its shareholders. And Wellington Management’s stock would trade at $6 per share, down 90% from its 1968 high of near $60. And, having given up too much stock to our new partners in the merger (who were largely responsible for our dismal performance) they fired me. My promising career had ended.

Warning to trustees and managers of corporate and state and local pensions: the 7 ½% future return your pension funds are assuming is simply not going to be there—not with a 50/50 stock/bond portfolio unlikely to earn a gross annual return of much more than 4%, maybe a net return of 3% after investment costs and 1% or less after inflation. Exceeding the market’s return—net of investment costs—may be possible for a single fund or manager. But it is impossible for all funds and managers as a group. Seeking out higher-than-market returns and accepting higher-than-market risks is rarely advisable. Going further out on the long limb of risk is a dangerous choice. (Limbs have been known to break.) Even in today’s environment of low expectations for future returns on financial assets, the most reliable strategy is to accept the markets’ returns, get your clients’ asset allocations right, hold investment costs to a minimum, and of course, keep your fingers crossed. That simple formula may not be the most brilliant investment strategy ever designed—especially to you who have done the challenging work of earning your CFA charters. But the number of strategies that are worse is infinite. We cannot know the future, but we should expect surprises and challenges. No matter what happens, there is one simple strategy that will never steer us wrong: put our clients’ interests first. At last, our investor/clients are poised to take their position at the forefront of our industry.

Financial Reform: Investment Standards and Ethical Values By John C. Bogle, founder of Vanguard before The Community Forum Distinguished Lecture Series of The Bryn Mawr Presbyterian Church Bryn Mawr, PA April 28, 2014 I last addressed this Forum eleven years ago. Since then, we’ve all seen remarkable changes in business, commerce, and finance in our nation . . . too many of them, alas, leading us in the wrong direction. Even worse, I think, is our failure to take significant steps to deal with the challenges that I outlined in those earlier remarks, entitled “What Went Wrong in Corporate America?” Then, my primary theme was the ascendance of a “bottom-line society” in our nation—measuring America’s success by our national output, our stock market, the earnings of our corporations, the strength of our businesses, our high standard of living, and the wealth—however unevenly divided—of our citizenry. I concluded that we were measuring “the wrong bottom line—form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring.” While that flawed “bottom-line society” remains dominant, tonight I’ll focus on how it has affected our nation’s financial sector, and distorted the interplay between the investment standards and the ethical values that now prevail in our world of finance. Both these standards and these values have deteriorated even further since last I spoke in this sanctuary.

Yes, events—perhaps even wisdom—were soon to reinforce my view of the appropriate structure for the fund industry, and to do something about it. First, I jumped on the Go-Go bandwagon, merging Philadelphia’s Wellington Management with a hot new fund manager from Boston. That horrible misjudgment was a monument to my sheer stupidity; to my naiveté; to my eagerness, even willingness, to ignore the lessons of financial history; to my (now-long-gone) focus on marketing; and in candor, to my interest in increasing the earnings and market value of then publicly held Wellington Management Company—largely owned by founder Walter Morgan, who had named me his successor in 1967. I was the Fund’s chief executive, and I had made an awful mistake . . . and paid for it. On January 23, 1974, I was fired by my new Go-Go partners of Wellington Management Company, adviser to the mutual funds we had ostensibly controlled. Strategy Follows Structure But the separate and largely independent boards of the Wellington mutual funds decided to keep me on as their chief. After a bitter struggle that lasted for eight months, the funds declared their independence from Wellington Management, and Vanguard was created. As I’ve often said, “strategy follows structure.” Vanguard’s unique, client-owned, truly mutual structure naturally led to—even demanded—a strategy that held the costs of investing to the bare minimum and allowed investors to keep their fair share of the market’s return.

More broadly, the management (or mis-management) of numbers is hardly the only instance of the dominance of numbers over reality in our society today.4 Our lives, as New York Times columnist David Brooks recently observed, “are now mediated through data-collecting computers.” Big Data, as it is called, “is really good at exposing when our intuitive view of reality is wrong . . . (giving us) wonderful ways to understand the present and the future.” Brooks continues . . . “Computer-driven data analysis excels at measuring the quantity of social interactions but not the quality. . . . Data creates bigger haystacks . . . many, many more statistically significant correlations, most of which are spurious and deceptive. The haystack gets bigger, but the needle we are looking for is still buried deep inside.”5 Worse, the trust that we place in numbers comes at the expense of trust in our own judgment and our values, and in our colleagues and communities. It’s bad enough when the focus on stock price over intrinsic value results in speculation and disrupts markets. But in the long run, business fundamentals trump market expectations that are based on current and expected numbers. When businesses rely too heavily on numbers, they tend to focus on the relatively predictable short run—on reported earnings and market expectations—than the far less predictable, but far more important, long run of creating durable intrinsic corporate value.

Remember to put the interest of your clients ahead of your own self-serving goals. (We all have self-serving goals; the question is where they stand in the hierarchy of our values.) 4. At least in the field of finance, never create anything solely for marketing reasons. “The crowd is always wrong.” Capitalizing on the fads and fashions of the day will, finally, serve your employers while hurting your clients. In my own career, I’ve made scores of mistakes—some major—but almost every bad decision I made came from placing “marketing” at the top of my priority list. I regret every one of them. 5. Never let your determination falter. Even when the world turns against you and ridicules your ideas, “Press on Regardless.but

seven months earlier—filed with the State of Delaware the Declaration of Trust for a new mutual fund that promised not to engage in the practice of active management. Originally named “First Index Investment Trust,” it was the world’s first index mutual fund. Its birth was, curiously, the product of a divorce. (Now there’s a paradox!) In 1966, as head of the long-established Wellington Management Company, I bet the firm’s future on a Boston firm—Thorndike, Doran, Paine, and Lewis—run by four aggressive equity managers operating a hot “Go-Go” fund named Ivest, managing a growing pension business, and having investment talent that, I believed, could more effectively manage the portfolio of our faltering Wellington Fund. Yes, I was young and foolish, and (even worse!) I was wrong. But for a time, the merged firm prospered, yet only until the “Go-Go” era came to its inevitable end. As 1973 began, the stock market began its terrible 50 percent crash, even worse for Ivest Fund, which never did recover. (It no longer exists.) Worse, Wellington Fund performance was also a disaster—the worst performing of all balanced funds in 1967-1977. Our new business model faltered, and then failed. In the merger, I had ceded substantial voting power to the new managers, and it was they who fired me as the leader of Wellington Management. On January 24, 1974, I was replaced by their leader, Robert W. Doran. I leave it to wiser heads than mine to explain the perverse logic involved in that outcome.

Is there something improper, or wrong, or unethical about having funds operated with this purpose? Perhaps not. But if this structure is not illegal per se, there seems to be something about the way in which the industry has evolved that flies directly in the face of the provisions in the Investment Company Act of 1940 that require that investment companies be “organized, operated, and managed” 2 in the interests of their shareholders, “rather than in the interest of their managers and distributors.”3 (Interestingly, the phrase mutual funds does not appear in the statute.) A Lone Exception to the Conventional Structure Now, when I said that virtually all funds operate under this external management structure, please note that I did not say all. The creation of Vanguard in 1974 marked my attempt to create a family of 2 Investment Company Act of 1940, 15 U.S.C. § 80a- 1(b)(2) (2000), available at http//www.sec.gov/about laws/ica40.pdf. 3 In re: The Vanguard Group, Inc., Investment Company Act Release No. 11,645, 22 SEC Docket 238 (Feb. 25, 1981).

I expected that becoming the low-cost provider in any industry where low cost (by definition) is the key to superior returns, would force our competitors to emulate our structure. Indeed, I chose the name “vanguard” in part because of its meaning: “leadership in a new trend.” But I was wrong. After more than three decades—during which at least one of our industry peers has described us as “the organization against which others must measure themselves”—we have yet to find our first follower.29 We remain unique. Of course, not everyone shares my view of the positive power of the mutual structure. Hear the American Enterprise Institute (AEI), in a recent book entitled Competitive Equity–A Better Way to 28 “Competition in the Mutual Fund Industry,” by John C. Coates IV and R. Glenn Hubbard, The Journal of Corporation Law, University of Iowa, Volume 33, Number 1, Autumn 2007, page 173-4. 29 I had hoped that when Marsh & McClennan decided to sell its Putnam Management Company subsidiary— obviously a deeply troubled firm whose previous management ill-served its investors in so many ways—it would mutualize and internalize its organization. However, my attempts to persuade three directors of the funds (including its then independent chairman) fell on deaf ears. The fund board approved the sale of the management to a Canadian conglomerate for $4.9 billion.

The Battle for the Soul of Capitalism Remarks by John C. Bogle Founder and Former Chief Executive, the Vanguard Group at The Aspen Book Series New York, NY March 14, 2006 Thank you very much for this special invitation to discuss my newest book, The Battle for the Soul of Capitalism, published in November by Yale University Press. It is indeed a pleasure to be with you all today. My book minces no words. Right at the outset, I turn to the main issue: “The business and ethical standards of corporate America, of investment America, and of mutual fund America have been gravely compromised. It is time to set out on a new course that, paradoxically enough, will lead us directly back to where we began, with the traditional values of capitalism. In the recent era, capitalism has let us down. It has departed, not just in degree but in kind, from its proud traditional roots, a system that served us, despite its imperfections, with remarkable effectiveness, for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work.” And then, as I write in Battle, “Something went profoundly wrong, fundamentally and pervasively, in corporate America.

I had come to discuss what was Vanguard’s then shocking pair of decisions to change our marketing strategy and structure: 1. To convert our Funds to no-load status by eliminating all sales charges, thus abandoning the dealer distribution system within which we had worked in partnership for nearly 50 years. 2. To “internalize” our new distribution system, having our Funds directly assume the responsibility for—and the cost of—all marketing activities, reducing our advisory fees more than commensurately, and thus reducing the total expenses borne by the Funds. The first decision was radical; the second, unique. Without precedent to guide us, we were entering a Brave New World. Doing so might seem obvious in retrospect, but it surely was frightening then. But beneath the fear was an underlying confidence far beyond what the facts would have justified. We assumed that the redemptions we might face from disgruntled dealers would not reach avalanche proportions. We also hypothesized that we could not lose much sales volume, for investor purchases of our shares were running at the puny monthly rate of $5 million. As it turned out, ten years later, in January 1987, investor purchases were $1.163 billion, a 200-fold increase. So, our no-load decision, it seems fair to say, has worked out well. We expected to complete the internalization of our distribution activities, as I said to you at that time, “effective (hopefully) May 1, 1977.” We were wrong.finally

” At the root of the problem, in the broadest sense, was the societal change aptly described by these words from the teacher Joseph Campbell: “In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business. We had become what Campbell called a ‘bottom-line society.’ But, at least in my view, our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” Let’s start with why you should—indeed must—care about our system of free-market capitalism. I argue that it is the job of every concerned citizen to “uphold the values that once made our corporate and financial enterprises so successful, fairly providing the rewards of investing to those who put up the capital and assume the risks involved. To win the battle to restore the soul of capitalism, it is these values that must prevail.” Why? Because, as I explain, “we require a powerful and equitable system of capital formation if our nation is to overcome the infinite, often seemingly intractable, challenges of our risk- fraught modern world. Our economic might, political freedom, military strength, social welfare, and even free religious values depend upon it.” ____________________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

Battle: “As the twentieth century of the Christian era ended, the United States of America comprehended the most powerful position on earth and the wealthiest portion of mankind.” So when I add Gibbon’s conclusion—“(Yet) the Roman Empire would decline and fall, a revolution which will be ever remembered and is still felt by the nations of the earth”—I’m confident that the thoughtful reader did not miss the point. But of course I hammer it home anyway: “Gibbon’s history reminds us that no nation can take its greatness for granted. There are no exceptions.” As one of two reviews—both very generous—of The Battle that appeared in The New York Times noted, “Subtle Mr. Bogle is not.” No, I’m not writing off America. But I am warning that we’d best put our house in order. “The example of the fall of the Roman Empire ought to be a strong wake-up call to all of those who share my respect and admiration for the vital role that capitalism has played in America’s call to greatness. Thanks to our marvelous economic system, based on private ownership of productive facilities, on prices set in free markets, and on personal freedom, we are the most prosperous society in history, the most powerful nation on the face of the globe, and, most important of all, the highest exemplar of the values that, sooner or later, are shared by the human beings of all nations: ‘certain inalienable rights . . . to life, liberty, and the pursuit of happiness.’” But something went wrong.

approved by the Securities and Exchange Commission until February 1981. To conduct business under a cloud of uncertainty for nearly four long years was a challenge, but we never lost confidence that the Commission would eventually support our Application. And finally, of course, it did. Referring to our two vital decisions, I concluded my decade-ago remarks by saying: “as we move into the 1980s, time will surely tell whether our risky judgment was right or wrong and . . . whether we were correct when we ignored that familiar advice from Lord Keynes: “Worldly wisdom teaches that it is better for reputations to fail conventionally, than to succeed unconventionally.” I believe that outcome of “The Vanguard Experiment: says that, at least in this one case, the worldly wisdom was wrong. But you who know this industry so well can make that judgment. Hits and Errors Given that my talk on “Marketing Mutual Funds in the 1980’s” is now a decade old, it might be fun to discuss for just a few moments two predictions I made then that were right and two that were wrong, as well as two developments that I missed that have come to pass. First, the hits. I modestly give myself an “A+” on pricing structure, boldly having predicted that the 1980s would obscure the then pure dichotomy between load funds and no-load funds.

“By the later years of the twentieth century, our business values had eroded to a remarkable extent”—the greed, egoism, materialism and waste that seems almost endemic in today’s version of capitalism; the huge and growing disparity between the ‘haves’ and the ‘have-nots’ of our nation; poverty and lack of education; our misuse of the world’s natural resources; the corruption of our political system by corporate money—all are manifestations of a system gone awry.” And here’s where the soul of capitalism comes in. The book reads, “The human soul, as Thomas Aquinas defined it, is the ‘form of the body, the vital power animating, pervading, and shaping an individual from the moment of conception, drawing all the energies of life into a unity.’ In our temporal world, the soul of capitalism is the vital power that has animated, pervaded, and shaped our economic system, drawing all of its energies into a unity. In this sense, it is no overstatement to describe the effort we must make to return the system to its proud roots with these words: the battle to restore the soul of capitalism. (One reviewer thought that the title was, well, “inflated,” but liked the book anyway.) This idealism doesn’t let up. The reader doesn’t even finish the first page of Chapter I (“What Went Wrong in Corporate America?

Only time will tell whether yet another Black Swan, lurking out there beyond the horizon, will become part of stock market history. Whatever the case, the fact that Black Swans can and do happen in our financial system holds important lessons for how we think about risk. While we look for corroboration of what we believe (confirmation bias), what we really ought to be looking for is the opposite—that observation that would prove us wrong. Sad to relate, we know what is wrong with a lot more confidence than what we know is right. Yet we continue to look ahead with apparent confidence that the past is prologue, based on our assumptions that the probabilities established by history will endure. The idea of seeking out evidence that contradicts our belief goes far beyond the financial markets. It goes to the very nature of knowledge itself. For the eminent British philosopher Sir Karl Popper—well- known for his use of the Black Swan metaphor—the key question was “what if science didn’t proceed from observation to theory? What if it was the other way around?” Writing in The New Yorker,2 journalist Adam Gopnik described Popper’s reasoning: “No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t . . .

And in my conclusion, I powerfully reaffirmed the ideals that I hold to this day: The role of the mutual fund is to serve—“to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible . . . The principal function of investment companies is the management of their investment portfolios. Everything else is incidental.” While all of this gratuitous advice from a callow college senior was, alas, largely ignored by the fund industry, the creation of Vanguard as a truly mutual mutual fund group—operated on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I talked the talk about all those years ago. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but in my new book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in that system. There is much that needs to be fixed, for “the business and ethical standards of corporate America, of investment America, and of mutual fund America (the three principal elements of the book) have been gravely compromised.” In each arena, I discuss not only what went wrong, but why it went wrong, and how to go about fixing it.

”) before reading: “At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.’ We had become what Campbell called a ‘bottom-line society.’ But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” II. Profession vs. Business Among the most obvious, and troubling, manifestations of the change from the stern traditional values of yore to the flexible values of our modern age—today’s “bottom line” society—is reflected in the gradual mutation of our professional associations into business enterprises. According to a 2005 article in Daedalus by Howard Gardner, Professor at the Harvard Graduate School of Education, and Lee S.

Right at the outset I warn the reader that mine is a tough message, bluntly delivered, opening with this epigram from St. Paul: “If the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?”, in this case; the battle for the soul of our capitalistic system. Today’s Capitalism Today’s capitalism has departed, not just in degree but in kind, from its proud traditional roots, a system that served us, admittedly imperfectly, but with remarkable effectiveness, for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work. And then, late in the twentieth century, something went wrong, a “pathological mutation in capitalism,” in the words of journalist William Pfaff.corporation’s

Science, Popper proposed, didn’t proceed through observations confirmed by verification; it proceeded through wild, overarching conjectures which generalized ‘beyond the data,’ but were always controlled and sharpened by falsification (i.e., proof that the theory was wrong).” “It was the conscious, purposeful search for falsification by refutation, by the single decisive experiment” (or swan), Popper believed, “that allowed science to proceed and objective knowledge to grow.” Yet most of us—in our investment ideas and political ideas alike—do quite the reverse: we search for facts that confirm our beliefs (reinforcement bias), not for the facts that would negate them. The Light Shined by Frank Knight In the markets, however, few theories are advanced with the search for falsification as the object, and we continue to speak of forecasts and probabilities.2002

Left was but a 25% share for the traditional equity-oriented funds, which had comprised 85% of industry sales volume in 1975. Talk about the challenge of change! The Investment Company Institute did not even carry a separate breakdown of bond fund statistics until 1975, and municipal bond funds did not come into existence until 1976, when enabling Federal legislation was enacted. If those were solid “hits,” surely there were gross “errors.” I could not have been more wrong when I predicted that “in the 1980s, (funds) will have to have lower operating expenses.” An “F” would be too generous a grade for that prognostication. The expense ratios of the 20 largest mutual fund complexes have risen from an average of 0.57 percent in 1977 to an estimated 0.80 percent in 1986. That 40 percent increase may not appear material, but it in fact represents a huge increase, for two reasons: 1.expenses,

” All of this gratuitous advice from a callow college senior was, alas, largely ignored by fund industry leaders. But the creation of Vanguard in 1974 as a truly mutual mutual fund group—operated on an "at-cost" basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but especially in my two latest books, which express profound concern about the deterioration in the values of our nation’s capitalistic system, in our concept of fiduciary duty, and in the operation of our financial markets. Part II. A Fiduciary Society The fact of the matter is that something has gone profoundly wrong in these critical areas. The root causes of the disease are deep, and the remedies that are required to cure it will not be easy to come by. What we have witnessed, in the words of journalist William Pfaff, is “a pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners, maximizing the return on their capital investment.in

I had no way of knowing that Walter L. Morgan, Class of 1920, would read my thesis. (I had sent it to a senior officer of Wellington Fund who had discussed the industry with me when I did my research.) Mr. Morgan was impressed, and when I graduated, he offered me a job. After what turned out to be an unnecessary amount of soul-searching, I accepted, and, as they say, the rest is history. Walter Morgan truly made a difference in my life. He gave me my first break, and he became my mentor. Then he entrusted me, at age 36, with the leadership of Wellington, the company he founded in 1928. But far more than that, we became close friends, establishing a mutual admiration society that endured for nearly a half a century, until his death last summer. He had just reached his 100 th birthday, still bright, alert, interested and interesting, the oldest then-living alumnus of the Class of 1920. When I decided to dedicate my soon-to-be-published book, Common Sense on Mutual Funds, to him, I had an advance copy of its cover and dedication printed and framed, and gave it to him before what was to be his last birthday. It includes the phrase “fellow Princetonian,” and we shared great pride in that designation. This morning, I know that in some mysterious way he’s here with us, sharing this high honor with me. Quickly after assuming my awesome new responsibility at Wellington, I impulsively made a career-threatening error.

dominate, with about 55 percent of equity fund assets of $6 trillion residing in load funds, and about 45 percent in no-load funds, a relationship that has been remarkably steady during the years. In its own perverse way, this contrast between the dominance of load funds in the equity field and no-load funds in the money market field makes sense. In money markets, where returns are relatively uniform, where the impact of costs is rather obvious, and where the hope of outperforming the market is non-existent, a sales commission would be regarded as an absurd drag on returns, indeed perhaps almost a fraud. On the other hand, in equity markets, where returns are highly variable, where the impact of costs is obscure, and where the hope of beating the market springs eternal, the sales agents of our brokerage firms ride in the saddle, dominating the asset base. What does this analysis have to do with bond funds? Plenty! Consider that in terms of those three major variables—uniformity of returns, obviousness of the impact of costs, and hope of outperformance—bond funds lie somewhere between equity funds and money market funds. So, an analyst might reasonably conclude that the market share of load and no-load funds would also lie somewhere between that 0/100 load fund/no-load fund split in money market assets and that 55/45 load/no-load split in equity funds. The analyst would be wrong.

If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary. The (likelihood) of opinion or estimate to error must be radically distinguished from probability or chance, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability (in which) any sort of statistical tabulation (provides) any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable . . .there is much question as to how far the world is intelligible at all . . . It is only in the very special and crucial cases that anything like a mathematical study can be made.” (Italics added.) Mandelbrot on Risk, Ruin, and Reward The abstract theories of Karl Popper and Frank Knight can be directly applied to the financial markets, which is exactly what Benoit Mandelbrot, the brilliant inventor of fractal geometry, has done with Richard Hudson in his book The (Mis)Behavior of Markets, ominously subtitled “A Fractal View of Risk, Ruin, and Reward.” Fractal geometry, simply put, is about patterns, patterns that repeat themselves continually, in nature and in geometry, scaling up or scaling down, sometimes defined by a determination rule, sometimes entirely by chance.

Buffett called them “financial weapons of mass destruction.” Greenspan said, “The benefits of derivatives have far exceeded their costs.” Buffett’s letter to shareholders devoted a whole section to derivatives, their abuse, and the great financial risk they represent both to the parties using them and to the economy as a whole, saying that derivatives could lead to huge financial turmoil for the markets. For Buffett, derivatives’ hard-to-quantify off-balance sheet presence makes it difficult to figure out a financial institution’s true market risk exposure—lurking like a looming iceberg beneath the economy’s waters. Greenspan countered directly by saying that most banks manage their risks just fine. Financial institutions use vehicles like swaps and futures to hedge their interest rate and market exposures, pointing out that the prudent use of derivatives has helped banks survive the recession by reducing risk. Buffett thinks they represent a huge risk to the economy and that some sort of further regulation is needed. Greenspan believes that the market can handle derivative risk, and that more regulation could create a moral hazard, actually encouraging banks to assume more risk instead of less. Who’s right? They both are, in a way. But so far the use of most derivatives goes unnoticed because nothing catastrophic has happened. This is a battle that’s likely to go on and on, with both sides holding fast to their positions until proven wrong by another big market event.

They are not improved by my second significant error, the prediction that “institutional markets— pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth.” Perhaps a “D” will reflect the actuality—that, according to Investment Company Institute data, the portion of our Industry’s assets represented by these institutional accounts eased only slightly upward during the past decade, from 12 percent to 14 percent. Put another way, mutual funds currently represent something like 2 percent of the assets of all corporate pension plans, by far the dominant institutional market. So, my supposition that mutual funds could penetrate these markets in an important fashion was just plain wrong. Nonetheless, it is at least possible that the proverbial “jury is still out” on this issue. I believe that the recent trend from the traditional defined benefit pension plans toward defined contribution plans, and the related growth of 401(k) employee savings plans, will open vast new markets for mutual funds. It continues to seem to me that there is no investment vehicle providing benefits comparable to those offered by mutual funds: “simplicity, efficiency, liquidity, and flexibility: (the words I used a decade ago). Indeed, “flexible pricing” has made it the norm for funds of all types—not merely no-load funds— to offer their shares in this giant market without sales commissions.

Lord Keynes’s confidence that speculation would dominate enterprise was based on the then- dominant ownership of stock by individuals, largely ignorant of business operations or valuations, leading to excessive, even absurd short-term market fluctuations based on events of an ephemeral and insignificant character. Short-term fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. While competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, Keynes added, should correct the vagaries caused by ignorant individuals, the energies and skill of the professional investor would come to be largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. He therefore described the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And I had the temerity to disagree with the great man, arguing that he was wrong.than

Another innovation is a variety of fixed-payout funds in which specific rates of annual withdrawals are offered, along with a warning that these payouts may, over time, exhaust the investor’s capital. (One can only hope that warning is in large boldface type.) Other innovations have included tax-deferred variable annuities that assure continued payouts (as a percentage of a fluctuating asset value), a perfectly good idea—except that the grossly excessive costs, commissions, surrender charges, etc., that burden most of these “products” have proved to erase much of their alleged advantage. And we also see new equity indexed annuities, usually providing only a portion of the stock market’s return while guaranteeing a minimal annual return in the 1 percent to 3 percent range. Even a rudimentary financial analysis suggests that these modest added values are unjustified by costs (and sales practices) that are anything but modest. Of course the major innovation of the recent era is the exchange-traded fund (ETF). I suppose there’s nothing wrong, as such, with an index fund that can be traded (as the advertisements say) “all day long, in real time.” But I have to wonder why any serious investor would want to do such a crazy thing.on

the outside looking in, and they are a small minority.) Their shared goal: To increase the price of a firm’s stock, the better to please “the Street,” to raise the value of its currency for acquisitions, to enhance the profits executives realize when they exercise their stock options, to entice employees to own stock in its thrift plan, and to make the shareholders happy. How to accomplish the objective? Aim for high long- term earnings growth, offer regular guidance to the financial community as to your short-term progress, and never fall short of the expectations you’ve established, whether by fair means or foul. What’s wrong with that? What’s wrong, as I said in my 1999 remarks, is that when we “take for granted that fluctuating earnings are steady and ever growing . . . somewhere down the road there lies a day of reckoning that will not be pleasant.” I was warning, of course, about the aftermath of the classic “new economy” bubble that had developed, where stock prices were wildly-inflated by unrealistic expectations and, well, irrational exuberance. Finally, the eternal truth re-emerges: The value of a corporation’s stock is the discounted value of its future cash flow. All over again, we learn that the purpose of the stock market is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realize the present value of a future stream of income at any time. Corporations, we again came to realize, must earn real money.

After a half-century observing this industry, I may have become too much the philosopher, maybe even too much the cynic. But it occurs to me that most mutual fund managers are barking up the wrong tree. I just can’t imagine that any of those foxes in the mutual fund industry don’t understand the simple arithmetic that gives the all-market index fund its powerful advantage, let alone the extra boost added by its extraordinary tax-efficiency. That I am virtually the industry’s sole apostle of indexing makes the thesis easy to ignore. But even when Warren Buffett, with his unchallenged credentials, speaks—“Most investors will find that the best way to own common stocks is through an index fund that charges minimal fees. . . it is certain to beat the net results delivered by the great majority of professionals”—this industry fails to listen. Except, that is, for the former chairman of one giant fund complex who defends his firm against the clear truth that underlies the superiority of the index with these words: “Investors ought to recognize that mutual funds can never (his word) beat the index.” The index fund is not merely another kind of mutual fund. It approaches investing, not as a matter of trading pieces of paper for advantage, but as a matter of owning businesses and watching them grow. Through an all- market index fund, investors own the shares of virtually every publicly-held business in the U.S., and hold them forever.

indeed—given the pressures on sales charges and dealer discounts, and the end of reciprocal brokerage. This distribution system is still a perfectly good one, but our judgment was that it is simply too much to expect it to generate, for perhaps 25 major fund groups, enough sales volume to at least offset liquidations—and that, of course, is the name of the game. Further, any business, especially a business in as troubled an environment as this one has been, has an obligation to make the very best judgments it can to survive and to grow; to say nothing of its obligation to provide efficient, economical and productive services, and good investment performance for existing shareholders. As we move into the 1980’s, time will surely tell whether our very risky judgment was right or wrong. And time will also tell whether we were correct when, by doing what we have done, we ignored that familiar advice from Lord Keynes: “Worldly wisdom teaches that it is better for reputations To fail conventionally, than to succeed unconventionally.”

” He was not above responding to a statement that there are two sides to every question with a curt, “Yes there are. A right side and a wrong side.” Nor was he beyond telling a colleague, “Do as you think best,” while always leaving underneath the veiled injunction, “but do it this way.” And as he freely admitted, he hardly become easier and more placable with age. “The older I get, the hotter I get,” Wilson said—and he was only 52 then! I confess that my colleagues at Vanguard might see these same traits in me. It was Wilson’s stubborn idealism that stood in the way of accomplishing his final goals while at Princeton—a collegiate campus—and while at the White House—a League of Nations. I can only recall F. Scott Fitzgerald’s statement: “Show me a hero, and I’ll write you a tragedy.” But is tragedy truly the right word? Both developments have now come to pass. And for me, whether one finally succeeds or fails, steadfast commitment to one’s own principles and values is what a man’s life is all about.nor

In our omniscient financial markets—dominated by smart, sometimes brilliant, professional investors—largely employed by financial institutions that just happen to be investing other people’s money—we are told, “Don’t think you know more than the market. Nobody does.” And yet I continue to believe, after Pascal, that we should consider not only the probabilities that the things that might go wrong actually come to pass, but their consequences. Even if our stock market professionals, with their intense focus on the short term, are unconcerned about the impact of these issues on the investors they serve, long-term investors, depending on accumulating assets for their retirement years, cannot afford to ignore them. It is here that I have serious concerns. (Full disclosure: while I’m an eternal optimist, I’m a conservative investor, believing that virtually every portfolio should have a portion in fixed-income securities as well as equity securities.) I can hardly contemplate the most dire consequences of, for example, the war in Iraq, nuclear proliferation, fragile sources of energy, the spread of religious fundamentalism, global warming, enormous federal budget deficits (with a political system unwilling to deal with them), and the massive potential shortfalls in the ability of our corporations, our cities and our states (to say nothing of our federal government) to fund their pension liabilities.

95 percent. However, it is not only the burden of expense ratios that most bond funds must overcome. It is the burden of sales charges as well. While the earlier data showing the ten-year results of a $10,000 initial investment in fact included the impact of sales charges on those funds charging sales commissions, it is in the nature of that data to amortize, in effect, the front-end sales charge over the full decade. But it turns out that bond funds are typically held by investors for only a relatively small fraction of a decade—actually only about three years on average. So all of those returns for the average bond fund I’ve shown earlier are overstated. One might think that, because of the sunk cost represented by the front-end load, investors in such funds would hold them for an extended period, lengthening the amortization period in order to reduce the negative impact on return. Wrong! (Chart 6) In fact, the holding period for load and no-load funds differ only slightly in the corporate area (about 2.8 years).But

Remember always that even one person can make a difference. And do your part ‘to begin the world anew.’” A single turn of the page takes you to five epigraphs (count ‘em, five!), the first of which comes from St. Paul: “if the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?” And in my acknowledgments, I get right to the point in the very first paragraph: “Capitalism has been moving in the wrong direction.” The introduction that follows doesn’t let up. I start off with a remarkably light revision of the classic first paragraph of Gibbon’s The Decline and Fall of the Roman Empire, adapted to the present era. Compare the two first sentences. Gibbon: “In the second century of the Christian Era, the Empire of Rome comprehended the fairest part of the earth and the most civilized portion of mankind.” Battle: “As the twentieth century of the Christian era ended, the United States of America comprehended the most powerful position on earth and the wealthiest portion of mankind.” So when I add Gibbon’s conclusion—“(Yet) the Roman Empire would decline and fall, a revolution which will be ever remembered and is still felt by the nations of the earth”—I’m confident that thoughtful readers do not miss the point. But of course I hammer it home anyway: “Gibbon’s history reminds us that no nation can take its greatness for granted. There are no exceptions.

As Karl Popper recognized, not only our market, but science itself, depends not on observations confirmed by verification, but on wild conjectures sharpened by falsification (proof that the theory is wrong). 3. Frank Knight focused on a critical distinction between risk—which is subject to measurement—and uncertainty—which is not. 4. Stock market returns, in the short-term, are not normally distributed, but are explained by the fractal patterns discovered by Mandelbrot. We can’t ignore the possibility—indeed, the virtual certainty—that such extreme patterns will persist, and we never know when. 5. Keynes’s insight was to separate stock returns into two elements, enterprise—subject to a reasoned financial analysis and speculation—the madness of crowds—which, he argued, would become increasingly dominant. 6. Bogle (if you will) applied numbers to Keynes’s insight, showing that future investment returns were subject to reasonable expectations, and that even speculative returns tended, over time, to move toward zero. 7. Minsky added a sobering note: the financial economy, focused on speculation, was not separate and distinct from the productive economy, focused on enterprise. Rather, the former would come to overwhelm the latter. 8 The Battle for the Soul of Capitalism, Yale University Press, 2005.

” As one of two reviews—both very generous—of The Battle that appeared in The New York Time noted, “Subtle Mr. Bogle is not.” No, I’m not writing off America. But my certain trumpet is warning that we must put our house in order. “The example of the fall of the Roman Empire ought to be a strong wake-up call to all of those who share my respect and admiration for the vital role that capitalism has played in America’s call to greatness. Thanks to our marvelous economic system, based on private ownership of productive facilities, on prices set in free markets, and on personal freedom, we are the most prosperous society in history, the most powerful nation on the face of the globe, and, most important of all, the highest exemplar of the values that, sooner or later, are shared by the human beings of all nations: the inalienable rights to “life, liberty, and the pursuit of happiness.” Something Went Wrong But something went wrong. “By the later years of the twentieth century, our business values had eroded to a remarkable extent”—the greed, egoism, materialism, and waste that seem almost endemic in today’s version of capitalism; the huge and growing disparity between the “haves” and the “have-nots” of our nation; poverty and lack of education; our misuse of the world’s natural resources; the corruption of our political system by corporate money—all are manifestations of a system gone awry. And here’s where the soul of capitalism comes in.

The book reads, “The human soul, as Thomas Aquinas defined it, is the ‘form of the body, the vital power animating, pervading, and shaping an individual from the moment of conception, drawing all the energies of life into a unity.’ In our temporal world, the soul of capitalism is the vital power that has animated, pervaded, and shaped our economic system, drawing all of its energies into a unity. In this sense, it is no overstatement to describe the effort we must make to return the system to its proud roots with these words: the battle to restore the soul of capitalism. (One reviewer thought that the title was, well, “inflated,” but liked the book anyway.) This idealism doesn’t let up. The reader doesn’t even finish the first page of Chapter I (“What Went Wrong in Corporate America?”) before reading: “At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.‘bottom-line

society.’ But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” That may seem a harsh indictment, but I don’t back away from it. Indeed, as International Herald Tribune columnist William Pfaff described it, what went wrong as “a pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on serving the interests of the corporation’s owners, maximizing the return on the capital they had invested and the risk they had assumed. But a new system had developed—managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” As you know from reading the book, there were two major reasons for this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 32 percent, while indirect ownership by institutional investors has soared from 8 percent to 68 percent.

As you look at that imposing long-term record for low-cost bond indexing, you might be surprised to learn that it could have been even more imposing. In its first decade, beginning with a tiny asset base of less than $100 million and ending at $4 billion, the VTBMF tracking error relative to its target, the Lehman Aggregate Bond Index, was about 45 basis points per year, largely as a result of higher (if still low) expenses and implementation costs on a relatively small asset base. Then, with larger asset size and superior implementation, the annual tracking error fell to an average of 14 basis points through 2001. Then in 2002, misfortune befell the Vanguard Total Bond Market Index Fund, providing lessons that tell us as much about the need for rigorous index management and rigorous control as they do about the risks of active bond management. After some bumps in the summer of 2001, the bond market fell into serious disarray early in 2002, largely because of a series of sharp downgrades in credit quality. The problems continued through June and July, when they reached crisis stage before at last stabilizing. In those two months alone, VTBMF lost nearly 140 basis points of tracking error, bringing the fund’s total lag to its target index for 2002 to an incredible 200 basis points, even more significant since it was derived entirely from the corporate sector (not the Treasury and mortgage-backed sector) which represented only 40 percent of VTBMF’s assets. Why did it happen?

provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds’ weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some “subsectors”—in contrast to historical experience— diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies. In recognition of the radical change in the market’s reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. Do those comments suggest that active management, reduced diversification, and investing for higher yield had found their way into indexing? I’ll let you make the call. I’m confident that the Vanguard Fixed-Income Group has learned much from the cascade of ill-tidings that led to such a shocking 200 basis point shortfall in the return of VTBMF to its target index, an assumption borne out by the fact that our annual tracking error has returned to its earlier excellence, and in fact looks even better.

growth fund with assets of $530 million reported, as all funds must, its sales and redemptions. Share sales for the year, $3,509,527,000, redemptions, $3,604,272,000. Redemption rate (calculated but not published), 679.2 percent. Average holding period, seven weeks. Is it possible that market timing was going on? You tell me. Tell me too, where the fund directors were, or for that matter, where the SEC examiners were, or even where the press was. A sad anecdote: in the spring of 2006, I spoke at the Union League Club of New York, afterward signing copies of my new book, The Battle for the Soul of Capitalism. One person who asked me to sign his book requested that I endorse it to him. When he told me his name, I recognized him as the man who was in charge of the administration of the fund I just described. He told me that he’d only recently been released from prison for allowing the rapid-fire trading to take place, and then trying to hide the evidence. He said he knew it was wrong, but the firm had always done it, and he felt compelled to go along. “Everyone else is doing it” strikes again. There’s a telling message there.prominently

Fixing a Broken Financial System Remarks by John C. Bogle Founder and Former Chief Executive, The Vanguard Group Before A Stradley, Ronan, Stevens & Young Assembly Philadelphia, PA February 12, 2009 I’m so pleased with this wonderful turnout—surely an indication that many leaders in our Greater Philadelphia business and legal community are deeply concerned by the financial crisis that continues to unfold as we meet. And I thank Stradley Ronan for giving me the opportunity to present my views to you, as well as their presenting each of you with my newest book—number seven—published just a few months ago. As it happens, in many respects, ENOUGH, anticipated—some say, predicted—the crisis in our markets and our economy. But the book also sends a message about the decline in our society’s character and values that we have witnessed over the past few decades. No one would have been more appalled by what has gone wrong than Stradley’s former senior partner, the late Andrew B. Young, Esq. I benefited greatly from Andy’s mentorship as Wellington Management Company’s counsel during the 25 years we worked together, as well as from the insight and wisdom of this great man for the remaining 25 years of his long life. So I take the liberty of dedicating these remarks to his memory. (Stradley, Ronan, Stevens & Young people here: never forget your fine heritage.

Economics, Politics, and the Financial Markets Remarks by John C. Bogle, Founder The Vanguard Group Former Chairman of the Board of Trustees of Blair Academy Blair Academy Reception New York, NY October 14, 2008 I guess that it’s fair to say that the timing of this gathering is, well, fortuitous. Better, I suppose, that I should speak to you after a 900-point rally in the Dow Jones average than speak to you just a few days ago, after a precipitous seven day decline of 2400 points, the culmination of a 40 percent decline from last October’s high. But this evening comes not only in the midst of infinite turmoil in the financial markets, but at the confluence of profound economic challenges (the global banking crisis, the collapse in home prices, and the onset of recession), and the portent of profound political change (our presidential election is exactly three weeks away). One might think that this turmoil has captured the rapt attention—and deep concern—of the American public. But one might be wrong, too. Here, for example, are the hottest searches on NYTimes.com during the week of September 28-October 4. Steve Fossett Elisabeth Hasselbeck FDIC’s failed bank list Heather Locklear Guitars for sale Angelina Jolie

Ethical Principles and Ethical Principals Remarks by John C. Bogle, Founder and former chief executive The Vanguard Group ∞ ∞ ∞ Upon receiving The Exemplary Leadership Award from The Center for Corporate Excellence at The “Charging the Game” Forum Denver, CO November 1, 2006 I’m deeply honored to receive your award. During my now 55-year career in the mutual fund industry I’ve done my best to meet your standard of “consistent ethical leadership.” But I freely confess that, perhaps like all of us, I could have provided even more leadership toward a better corporate and investment America. In whatever years may remain, I pledge to you this evening that I will “press on, regardless” in this quest.1 The title of my remarks this evening arises from, of all things, a typographical error. In a mailing sent out by the Center for Corporate Excellence earlier this year to announce that General Electric would receive your Long Term Excellence in Corporate Governance award, you quoted GE President Jeffrey Immelt on the importance of “sound principals of corporate governance.” But while the quotation said, yes, principals, it clearly meant principles. I can’t help myself from noticing that sort of stuff (query whether it’s a strength or a weakness!), and as I did, it occurred to me that there might be a speech in that distinction.

broader and less parochial than mine to finance, for a long time we have shared a profound concern about the change in the character of the fields of our life’s work: from a professional culture focusing on the human beings whom we are duty bound to serve, to a business culture in which the proverbial “bottom line” has become the overriding goal of our enterprises. The trouble with that change must be obvious: in the words from my book Don’t Count on It!, in today’s bottom line society, we seek the wrong bottom line: money over achievement, form over substance, charisma over character, prestige over virtue, the ephemeral over the enduring. Dr. Lown’s concerns about the profession of medicine are almost interchangeable with my own concerns about the profession of trusteeship. Let me cite one of his paragraphs, in which I’ve simply changed his healthcare words into my mutual fund words—“patient” becomes “client,” “doctor” becomes “money manager,” and so on: Our profession’s fundamental ethics are under assault. Investment management is a calling—at its core a moral enterprise grounded in a covenant of trust between money managers and clients. The primary mission of the manager is to invest wisely, to promote the client’s financial well-being. Central to the relationship is the expectation that the manager will put the needs of the client first.

But our society, I think, is measuring the wrong bottom line: not only money over achievement, but form over substance; prestige over virtue; charisma over character; the ephemeral over the enduring; even mammon over God. Dollars have become the coin of the new realm, and unchecked market forces totally overwhelmed traditional standards of professional conduct, developed over centuries. ____________ The views expressed in this speech do not necessarily reflect the views of Vanguard’s present management.

In 1954, MIT (now part of Massachusetts Financial Services, or MFS) lost its crown to Investors Diversified Services, (IDS) which became part of American Express, and then spun off as Ameriprise Funds, and just recently (through a merger), Columbia Funds. (No, I’m unable to rationalize how this kind of trafficking in mutual fund advisory fee contracts advances the interests of shareholders of the mutual funds involved.) IDS also wore the crown for a long time—24 years—through 1978, reaching a peak market share of 14 percent of industry assets. I’m confident that this audience knows who ultimately took that crown away from IDS.* Fidelity’s stunning ascent to industry leadership began in 1979, and it would hold that lead through 2005, a remarkable 26-year record of durability, with its market share peaking at a 13 percent share of industry assets. (You may be puzzled, as am I, why it took the financial press another four years to recognize Vanguard as Fidelity’s successor. Perhaps this oversight is explained by the fact that the firms were neck-and-neck in 2006- 07-08, with Vanguard sometimes ahead by as little as $3 billion, rounding error at these trillion-dollar levels.) In any event, Vanguard now firmly holds the undisputed crown of industry leadership. Our 13 percent market share is rapidly approaching the share level of the previous title-holders. The Vanguard-Fidelity rivalry, however, is rather complex. While our $1.468 trillion asset total exceeds Fidelity’s $1.

As you may have already figured out, those words (except for the very first sentence) are not mine. Rather they are the words of Harlan Fiske Stone, excerpted from his 1934—yes, 1934—address at the University of Michigan Law School, reprinted in The Harvard Law Review later that year. But his words are equally relevant—perhaps even more relevant—on this very day. For they could hardly present a more appropriate analysis of the causes of the present-day collapse of our financial markets and the economic crisis now facing our nation and our world. You could easily react to Justice Stone’s words by falling back on the ancient aphorism, “the more things change, the more they remain the same,” and move on to a new subject. But I hope you’ll react differently, and share my reaction: In the aftermath of that Great Depression and the stock market crash that accompanied it, we failed to take advantage of the opportunity to demand that our giant businesses and financial organizations—the trustees of so much of our nation’s wealth—measure up to the stern and unyielding principles of fiduciary duty described by Justice Stone. So, 75 years later, for heaven’s sake, let’s not make the same mistake again. The Columbia Connection Given this history and this topic, it seems singularly fitting to present this lecture at Columbia University. For Harlan Fiske Stone (1872-1946) ranks among Columbia’s most distinguished sons.

instructions. (There were no cell phones in those days.) I figured it would take more than a half- hour on two different trolleys to get there. (I had no car.) It was late; I was tired, and, truth told, I was a bit bored. A house fire, for heavens sake! So I skipped the trip and got a report from the firemen when they returned. I called in the story, but the wise rewrite man quickly figured out that I had not actually gone to the scene. “What color was the house?” he boomed. To which I responded, “I’m sorry. I was wrong. I’ll get over there right away.” And I did. The house turned out to be grey, with green trim. The moral of the story, which I urge upon you: “Whatever you do in your careers, do every job with commitment, with professionalism, and with excellence, and never, never take short-cuts.” If you get nothing more out of my remarks this evening on business, please remember that lesson, which has stuck with me ever since, and has represented the standard which I’ve tried my best to honor throughout my long career in the financial field. Complete information and punctilious accuracy are the responsibility of business in all of its communications to all of its constituents, including the media and the public. Let me begin by describing the philosophy that undergirded my actions in dealing with our various publics during my quarter-century as chief executive and then as senior chairman of Vanguard.

I. Principals and Principles The first of these three subjects focuses on the title I have chosen for my remarks this afternoon—“Ethical Principles and Ethical Principals.” That talk was inspired by, of all things, a typographical error. A mailing I received a few years ago announced that General Electric would receive an award for long-term excellence in corporate governance; GE President Jeffrey Immelt was quoted as focusing on the importance of “sound principals of corporate governance.” But while the quotation spelled principals with the concluding a-l-s, Mr. Immelt clearly meant principles, with the concluding l-e-s. But, at least in this instance, that is distinction without a difference. After all, no matter how strong the ethical principles of the world of business may be, of what use are they without ethical principals to honor them, especially ethical leaders who have the responsibility to assure that these ethical principles permeate and dominate the culture of our corporate world?1 I describe these classic ethical principles of our society in words very similar to those of Steven Pinker— integrity, honesty, and trustworthiness; fairness and justice; doing good and preventing harm; concern for the well-being of others and respect for their autonomy, and so on. But applying these societal principles to business principals is far easier said than done.

Main Street bailing out Wall Street for its disgraceful conduct . . . it doesn’t seem fair, does it? Well, it isn’t! But the rampant greed that has overwhelmed our financial system and corporate world runs deeper than money. Not knowing what enough is subverts our society’s traditional values, as self-interest and greed replace community interest, professions behave as businesses, money vs. service to the community, and service to self takes priority over service to others. This confusion about what is enough leads us astray in our larger lives, as we too often bow down at the altar of the transitory and finally meaningless; and we fail to cherish what is beyond calculation, indeed eternal. Unchecked, our failures ultimately result in the diminution of our national character and values. So in a broader sense, we all bear some of the responsibility for what has gone wrong in America. That message about our society’s worship of wealth and the growing corruption of our ethics, I think, is what Joseph Heller captured when he spoke that powerful single word . . . enough. A Speech at Georgetown I was so inspired by Vonnegut’s poem that, in my commencement address at Georgetown University’s business school two years later, I used it to send a message. It was May of 2007, only a few short months before the great bubble that had enveloped our stock market, our financial system, our real estate holdings, and our economy would begin to burst.

government interventions aimed at containing the deterioration (are often) inept in historical crises.” It remains to be seen whether he was right or wrong on that point. Minsky concluded that over long periods of prosperity, the economy transits from financial structures that make for a stable system to structures that makes for an unstable system; i.e., that “stability leads to instability,” largely through what he described as hedging, speculation and Ponzi finance. With these words, all those years ago, Minsky proved a prophet of today’s crisis. Another of his insights was also prophetic: “Institutional complexity (for example, today’s collaterized debt obligations and credit default swaps) may result in several layers of intermediation between the ultimate owners of the communities’ wealth, and the (business and individual) units that operate and control the communities’ wealth.” This separation between ownership and control has now come to pass. In our old ownership society 92 percent of all stocks were owned by individuals and 8 percent by institutions. But in today’s agency society, only 24 percent of stocks are owned by individuals, with the remaining 76 percent held by institutions.the

responsibility must always be to their shareholders.” Shortly thereafter, “there is some indication that costs are too high,” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” (My advice, however, fell upon deaf ears.) After analyzing mutual fund performance, I concluded that “funds can make no claim to superiority over the market averages,” perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world’s first index mutual fund. Still later in the thesis, I urged that “fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund’s managers.” (Again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most funds.) Finally, I predicted that rather than engaging in short-term speculation focused on forecasting the psychology of the stock market, funds would bring far greater focus on wise long- term investment. Defying Lord Keynes’s prediction that professional investors would join the ignorant crowd of stock traders, I predicted that fund managers would be “steady, sophisticated, enlightened, and analytic” institutional investors, focused on corporate performance and intrinsic value rather than momentary and evanescent share prices. (Once again, I was wrong.

The proximate causes of the current financial and economic crisis are usually laid to easy credit; the cavalier attitude toward risk of our bankers and investment bankers; “securitization,” in which the traditional link between borrower and lender was severed; the extraordinary leverage built into the financial system by derivative securities of mind-boggling complexity; and the failure of our regulators to do their job. But the larger cause of the present crisis was our failure to recognize the sea-change in the nature of capitalism that was occurring right before our eyes. The “Agency Society” Displaces the “Ownership Society” That change in capitalism, simply put, was the growth of giant business corporations, controlled not by their own shareholders, but by the agents of the ultimate owners. What went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, in which the rewards of investing went primarily to those who put up the capital and took the risks, to a new and virulent managers’ capitalism, where an excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. Two major trends set the stage for this baneful change: First, the old “ownership society” shrank radically in size and importance. Only a half-century ago, 92 percent of all shares of our corporations were held by direct stockholders.percent

and elegance”2—the very kind of ingenious simplicity and effectiveness that characterize the index fund. It is the antithesis of the discredited “financial engineering,” the excessive costs, the product complexity, and the rampant speculation that created the global financial crisis that Wall Street has inflicted on Main Street. We created the first index mutual fund in 1975, and today it is the largest mutual fund in the world.3 This afternoon, I’d like to discuss the current state of our economy and financial markets, with the emphasis first on what went wrong, and second on what we might do to assure that our financial system takes on a greater sense of public purpose. I’ll do so by focusing on four quotations from Adam Smith, ranging from the obvious to the prophetic, to the idealistic. I’ll conclude with a few closing words about how all of this fits in with the message of my new book, Enough. True Measures of Money, Business, and Life. Adam Smith I – The Invisible Hand To say that the nation’s financial sector has ignored the principles of efficiency and economy—to say nothing of elegance—would be to put one’s head in the sand. The fact is that the bubble that led to the current financial and economic crisis; the easy credit; the cavalier attitude toward risk taken by our bankers and investment bankers; “securitization,” in which the traditional (and essential!)

on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about nearly a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard but in my Battle book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in our financial system. 2. A Parable So what’s gone wrong? Let’s begin with a parable that describes how the system really works. It’s my version of a story told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 annual report, and it clarifies the foolishness and counterproductivity of our vast and complex financial market system. Here goes: Once upon a time . . . a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game.

demand loyalty from their employees even as they fail to honor in return the loyalty to their employees that would seem a quid pro quo of that demand. And how about the integrity of the firm’s financial statements, let alone the true independence of the independent auditor who attests to their conformity with generally accepted accounting principles (GAAP)? With the looseness that prevails among the myriad detailed standards developed to implement those accounting principles, small wonder that the engineering wonder of our age is financial engineering. I am not necessarily arguing that our business principals are less ethical then their predecessors. But I am arguing that our business principles have been diluted. It seems to me there are far fewer absolute standards in the conduct of business—things that one just doesn’t do—and much more reliance on relative standards. “Everyone else is doing it, so I can do it, too.” (Think about executive compensation, stock options, and the multiple facets of financial engineering.) What Went Wrong in Corporate America and Investment America? So why did all these things go wrong?

Thus, long-term investing in America is a winner’s game that depends on the ability of business to earn a return on their capital; short-term speculation is a loser’s game that depends on outguessing other investors with enough skill (or luck) to overcome those substantial croupier costs, which I estimate at a staggering $500 billion per year. (Mutual fund costs, even ignoring their substantial portfolio turnover costs, will exceed $100 billion this year alone.) So if stock market participants were rational wealth-maximizers—simply preferring to play a winner’s game rather than a loser’s game—investment ought to be steadily gaining over speculation. Right? Wrong! Consider that during most of my first 15 years in this industry (through about 1966), it was not that way. Fund turnover averaged about 16 percent per year—let’s call that “investing,” a six- year average holding period—and never varied significantly from that norm. (Chart 3) But turnover moved steadily upward, and in the past decade, has averaged nearly 100 percent per year—let’s call that “speculation,” a one-year average holding period—exactly the opposite of my expectations when I joined this industry all those years ago.

Simply put—and this is the main thesis of my latest book, The Battle for the Soul of Capitalism—what went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, where the rewards of investing went primarily to those who put up the capital and took the risks—to a new and virulent managers’ capitalism, where an excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. There were two major reasons for this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. It is not going to return. In its stead, a new “agency society” has developed, with financial intermediaries controlling the overwhelming majority of shares. (Since 1950, institutional ownership has risen from 8 percent of U.S. stocks to 68 percent; individual ownership has dropped from 92 to 32 percent.) But those agents haven’t behaved as owners. They failed to honor the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should?

what has gone wrong in our nation’s corporate, financial, and mutual fund sectors, while The Little Book offers common sense advice on how to invest intelligently for the long term. (Hint: It recommends index funds as the core investment in individual & institutional portfolios.) Investment and Speculation Now, before I turn to the recent turbulence in the markets that I’m sure is on many of your minds this evening, I want to focus on the fundamental distinction between investment and speculation that I first touched on in that ancient thesis. Echoing the inspired wisdom of Lord Keynes, I defined investment as “forecasting the prospective yield on an asset” over its entire life. (Keynes used the term enterprise to describe this practice; today finance teachers describe it as discounted future cash flow.) Speculation, on the other hand, is “the activity of forecasting the psychology of the market.” When I speak of investment return, I speak of the current dividend yield on stocks plus their subsequent rate of earnings growth, together representing the real return on corporate capital. When I speak of speculative return, I speak of the impact of the change in the number of dollars that investors are willing to pay for each dollar of corporate earnings. Simply add the two together and, viola!

A Pathological Mutation in Capitalism But the larger cause of the present crisis was our failure to recognize the sea-change in the nature of capitalism that was occurring right before our eyes. That change, simply put, was the growth of giant business corporations, controlled not by their own shareholders, but by the agents of the ultimate owners. What went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, in which the rewards of investing went primarily to those who put up the capital and took the risks, to a new and virulent managers’ capitalism, where an excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. There were two major reasons for this baneful change: First, the old “ownership society” shrank radically in size and importance. Only a half-century ago, 92 percent of all shares of our corporations were held by direct stockholders.of

These three interlinked subjects would become the three main sections of my book: corporate America, investment America, and mutual fund America. Each subject was in turn organized into three sections—what went wrong, why it went wrong, and how to fix it. Organizing the new book was the easy part. But I also wanted to provide three special perspectives. The first, of course, was borne of my own first-hand experience as a participant in and close observer of business and finance for more than a half century; second, to draw on the wisdom of the best and brightest investment thinkers of our age; and third, to emphasize the lessons we might learn from history, and the reinforcement we might find in the traditional values of American society.

Median family income is now actually lower than it was a decade ago, despite the enormous increase in incomes earned by the top 1/100th of 1 percent of the population. Our nation’s wealthiest 15,000 families report an average annual income of $27 million, in contrast to the $31,000 average income of the lower 90 percent of our families, 135,000,000 in all, including nearly 9 million living below the poverty line of about $18,000 per year. Today’s “state of contentment,” then, likely applies to only a small fraction of our population. Coolidge, I’m confident, would have worried about this growing disparity. Help for the disadvantaged was an important part of his political philosophy. “Government is not, must not be, a cold impersonal machine,” he said, “but a more human agency, satisfying the heart, full of mercy, assisting the good, resisting the wrong, delivering the weak from any impositions of the powerful.”

With the looseness that prevails among the myriad detailed standards developed to implement those accounting principles, small wonder that the engineering wonder of our age is financial engineering. I am not necessarily arguing that our business principals are less ethical then their predecessors. But I am arguing that our business principles have been diluted. It seems to me there are far fewer absolute standards in the conduct of business—There are some things that one just doesn’t do—and much greater acceptance of relative standards—Everyone else is doing it, so I can do it, too. (Think about executive compensation, stock options, and the multiple facets of financial engineering.) As moral relativism comes to supersede moral absolutism, our society is moving in the wrong direction.

(Leave aside that some of those gains reflected, well, irrational exuberance, and represented, well, “phantom returns” destined to vanish.) And our professional money managers, rather than acting as long term investors— serving as vigilant stewards of our assets and acting as prudent trustees for the mutual fund investors and the pension fund beneficiaries they were duty bound to serve—have instead largely become short-term speculators, behaving as stock traders and placing their own interests ahead of the interests of their clients. Fathers of the Crisis There is plenty of responsibility to spread around for what went wrong. So while it is often said that “victory has a thousand fathers, but defeat is an orphan,” the defeat suffered by investors in our devastating financial crisis seems to have, figuratively speaking, a thousand fathers.stock

What Went Wrong in Corporate America and Investment America? So why did all these things go wrong? Simply put—and this is the main thesis of my 2005 book, The Battle for the Soul of Capitalism—what went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, where the rewards of investing went primarily to those who put up the capital and took the risks—to a new and virulent managers’ capitalism, where a grossly excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. As I see it, there were two major reasons for this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. It is not going to return. In its stead, a new “agency society” has developed, with financial intermediaries controlling the overwhelming majority of shares. (Since 1950, institutional ownership has risen from 8 percent of U.S. stocks to 70 percent; individual ownership has dropped from 92 to 30 percent.) But those agents haven’t behaved as owners. They have put their own interests ahead of the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. The whole notion of stewardship seemed to get lost in the shuffle.

Idealism Writ Large The Battle is one idealistic book! Just consider its first words, with the dedication to my twelve grandchildren and the other fine young citizens of their generation: “My generation has left America with much to be set right; you have the opportunity of a lifetime to fix what has been broken. Hold high your idealism and your values. Remember always that even one person can make a difference. And do your part ‘to begin the world anew.’” One turn of the page takes you to five epigraphs (count ‘em, five!), the first of which comes from St. Paul: “if the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?” And in my acknowledgments, I get right to the point in the very first paragraph: “Capitalism has been moving in the wrong direction.” The introduction that follows doesn’t let up. I start off with a remarkably light revision of the classic first paragraph of Gibbon’s The Decline and Fall of the Roman Empire, adapted to the present era. Compare the two first sentences. Gibbon: “In the second century of the Christian Era, the Empire of Rome comprehended the fairest part of the earth and the most civilized portion of mankind.” Battle: “As the twentieth century of the Christian era ended, the United States of America comprehended the most powerful position on earth and the wealthiest portion of mankind.

So we must have a lot more investors than speculators in our markets, right? Wrong! During the recent era—right up to this very day—the wisdom of long term investing has been overwhelmed by the folly of short-term speculation.—an orgy of speculation the likes of which has never been seen before. It’s true! During the then-record speculation of 1929, for example, annual turnover of stocks reached a record level of 145 percent. When I came into this business all those years ago (the ancient 1950s), turnover had returned to a more normal level of about 30 percent annually. But by last year, turnover had soared to 280 percent, and this year it is on track to exceed 325 percent—great news for the financial sector, the brokers, the investment bankers, and the money managers; but terrible news for investors.

I cited Keynes’s conclusions, and then had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these pros would focus on enterprise. In what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional managers has failed abjectly to materialize. Rather, the emphasis on speculation by mutual funds has increased many fold. He was right. I was wrong. Ah, callow youth! Call the score, Keynes 1, Bogle 0. Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added that “by very uncertain I do not mean the same thing as ‘improbable.to

ownership of productive facilities, on prices set in free markets, and on personal freedom, we are the most prosperous society in history, the most powerful nation on the face of the globe, and, most important of all, the highest exemplar of the values that, sooner or later, are shared by the human beings of all nations: the inalienable rights to life, liberty, and the pursuit of happiness.” Something Went Wrong But something went wrong. “By the later years of the twentieth century, our business values had eroded to a remarkable extent”—the greed, egoism, materialism and waste that seems almost endemic in today’s version of capitalism; the huge and growing disparity between the “haves” and the “have-nots” of our nation; poverty and lack of education; our misuse of the world’s natural resources; the corruption of our political system by corporate money—all are manifestations of a system gone awry. And here’s where the soul of capitalism comes in. The book reads, “The human soul, as Thomas Aquinas defined it, is the ‘form of the body, the vital power animating, pervading, and shaping an individual from the moment of conception, drawing all the energies of life into a unity.’ In our temporal world, the soul of capitalism is the vital power that has animated, pervaded, and shaped our economic system, drawing all of its energies into a unity.

Ogilvie (1951-52); Edwin Crysler, CFA (1959-60); John Neff, CFA (1971-72); Paul Mecray (1991-92); and the first Vanguard crew member to serve as your president, Walter Lenhard, CFA (2007-08). Perhaps because of my creation and leadership of Vanguard, along with my voluminous writings on finance and investing, in 1991 your Society invited me to introduce Walter L. Morgan, founder of Wellington Fund and my great mentor, when he was honored with your Lifetime Award of Distinction. Two years later, I was honored to receive that same prize from your Society. To my humble delight, your award was presented to me by the late Elliott Farr (mentioned earlier), the paradigm of the trust officer whom we would all, well, trust. Some of his words were prophetic. Referring to the “Boston situation” I described earlier, Elliott said it was “probably a serious business mistake at the time, but it ultimately engendered something much more dynamic than if the original combination had been reasonably successful. Restructuring is now a buzzword, but Vanguard’s creation and evolution represents the quintessence of dynamic restructuring before the word had any currency at all.” You were right, Elliott, and I’m honored to remind today’s analysts of the high standards you set for our profession. III. The CFA Institute2 Now, I’d like to turn to the development of the international CFA Institute itself. To do that, I’ll take you back in time in the annals of financial analysis.

Their creation and promotion of infinitely complex credit instruments (often debt obligations collateralized by mortgages, known as CDOs) led to the mass marketing of mortgages of dubious creditworthiness bundled in packages. In addition, an enormous system of betting on whether these bonds would or would not default (using “credit default swaps,” or CDS) emerged, and spread its tentacles to financial institutions all over the globe. The notional value of CDS market—gambling on a bank’s creditworthiness—now totals an astonishing $62 trillion. Now the CDS is merely a way to speculate on whether a bond will default or not. Investors pay an insurance premium to bet “yes” or “no,” and the premium varies with how speculators regard the likelihood of default. Simple enough, until your realize that that $62 trillion is being bet on only $2 trillion of underlying bonds. Talk about gambling! A homely comparison: Let’s say you insure your house with $700,000 of fire insurance. Then, 62 of your neighbors bet that it will burn down, and 62 other neighbors take the other side, betting that it won’t. You might say, “what’s wrong with that”, to which I’d respond, “just watch out for arsonists.huge

But our society, I think, is measuring the wrong bottom line: not only money over achievement, but form over substance; prestige over virtue; charisma over character; the ephemeral over the enduring; even mammon over God. Dollars became the coin of the new realm, and unchecked market forces totally overwhelmed traditional standards of professional conduct, developed over centuries. The result has been a marked change in our society. The traditional standard of conduct in which “there are some things that one simply does not do,” took a back seat to a new standard: “if everyone else is doing it, I can do it too.” I would describe this change as a shift from moral absolutism to moral relativism. The moral themes of virtue, loyalty, fidelity, faith, and honor have been debased. Business ethics has been a major casualty of that shift in our traditional societal values, and the idea of professional standards has been lost in the shuffle.

In this sense, it is no overstatement to describe the effort we must make to return the system to its proud roots with these words: the battle to restore the soul of capitalism. (One reviewer thought that the title was, well, “inflated,” but liked the book anyway.) This idealism doesn’t let up. The reader doesn’t even finish the first page of Chapter I (What Went Wrong in Corporate America?) before reading: “At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.’ We had become what Campbell called a ‘bottom-line society.’ But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” What went wrong this time, as International Herald Tribune columnist William Pfaff described it, was “a pathological mutation in capitalism.system—owners’

fund industry, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation [Keynes’ enterprise], rather than the public appraisal of the value of a share, that is, its price.” Alas, the steady sophisticated, enlightened, and analytic demand I had predicted from our expert professional investors is nowhere to be seen. Quite the contrary! Our money managers, following Oscar Wilde’s definition of the cynic, seem to know “the price of everything but the value of nothing.” Portfolio turnover of equity mutual funds, then running steadily about 15 percent, year after year—a six-year average holding period for the average stock in a fund’s portfolio—actually soared skyward. In recent years, fund turnover has averaged above 100 percent—an average holding period of less than one year. So, a half-century after I wrote those words in my thesis, I must reluctantly concede the obvious: the worldly-wise Keynes was right, and that the callously idealistic Bogle was wrong. Call the score, Keynes 1, Bogle 0. It wasn’t even a close fight! “The Job of Capitalism is Likely to be Ill-Done” During the recent era, we have paid a high price for the shift that Keynes so accurately predicted.

“Yet,” Lincoln adds “as was said three thousand years ago, so still it must be said, ‘the judgments of the Lord are true and righteous altogether,’” words from Psalm 19. He closes with this familiar but utterly breath-taking coda, “With malice toward none; with charity for all; with firmness in the right, as God gives us to see the right, let us strive on to finish the work we are in; to bind up the nation’s wounds; to do all which may achieve and cherish a just and lasting peace, among ourselves, and with all nations.” Those powerful—indeed, eternal—words could easily represent a prayer for our nation on this very afternoon. A Moral Society History tells us much, then, of men and milestones. But history also illuminates where we have fallen short, where we in our society have done what we ought not to have done, and not done what we ought to have done. Gradually, over the course of the past century, I fear that our society has lost much of stern morality that characterized our early religion’s leaders and statesmen. As I wrote in my recent book—The Battle for the Soul of Capitalism—“In medieval times, when a traveler approached the city, his eye was captured by the cathedral. Today, his eye is taken by the towers of commerce. It’s business, business, business, a bottom-line society in which we measure the wrong bottom line, form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even Mammon over God.

Indeed, one Vanguard shareholder described it as “a crisis of ethic proportions” (a nice variation on the standard “epic” proportions), the title that I used for my op- ed essay published in The Wall Street Journal a week ago. For the decline in ethical values played a major role in the failure of managerial capitalism and—managerial capitalists—that led to the financial bubble, and the burst that inevitably followed. While former Federal Reserve Chairman Alan Greenspan believed that competition and free markets would reward trust and integrity, he seemed unmindful of this sea-change in capitalism that was occurring. To his credit, Greenspan admitted his mistake. In his testimony before Congress last October, he acknowledged that the crisis had been prompted by “ . . . the collapse of a whole intellectual edifice . . . Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief,” he said. This failure of self-interest to provide self-regulation was, he added, “a flaw in the model that I perceived as the critical functioning structure that defines how the world works.”

I know something about how the financial system works, for I’ve been part of it for my entire 58-year career. The mutual fund industry is the paradigm of what’s gone wrong with capitalism. Here are just a few examples of how far so many fund managers have departed from the basic fiduciary principle that “no man can serve two masters,” despite the fact that the 1940 Act demands that the principal master must be the mutual fund shareholder: 1. The domination of fund boards by chairmen and chief executives who also serve as senior executives of the management companies that control the funds, an obvious conflict of interest and an abrogation of the fiduciary standard. 2.financial

Annualize the change, and then combine the two. But never forget that it's unwise in the extreme to forecast stock returns based on historical norms rather than on evaluating the broad forces that have shaped them in the past and will continue to shape them in the future. But whatever returns the stock market is generous enough to deliver in the years ahead, please don't make the mistake of thinking that those pre-inflation, pre-investment-cost figures have anything to do with reality.are

Yet the ideal owner is a long-term stockholder, perhaps even a permanent owner, whose goals are closely aligned with those of the corporation, The Economist of London expressed it well: “Everything now depends on financial institutions pressing even harder for reforms to make boards of directors behave more like overseers, and less like the chief executive’s collection of puppets . . . Financial institutions must also fight to restore their rights as shareholders and use their clout to elect directors, who would be obliged to represent only their collective interest as owners. Chief executives will still run their firms; but, like any other employee, they would also have a boss.” The giant institutions of investment America must take the lead in accomplishing these goals. Our money managers not only hold 75 percent of all shares, but they have the staff to pore over corporate financial statements and proxies; the professional expertise to evaluate CEO performance, pay, and perquisites; and, once full disclosure of all proxy votes (by pension funds as well as mutual funds) becomes mandatory, the incentive to vote in the manner that their beneficiaries have every right to expect. Their dereliction of duty in these areas also bears an important responsibility for what went wrong in our financial sector. (Who, for example, was analyzing those toxic balance sheets of our banks?)

therefore, business executives became increasingly attuned to short-term profits and the stock-market valuation of their firm. The growing role of institutional investors fostered continued financial-system evolution by providing a ready pool of buyers of securitized loans, structured finance products, and myriad other exotic innovations . . . something (is) basically wrong with the financial structure.” My own views of our flawed financial system closely parallel these views of Minsky and Keynes. Let me turn, then, to my own concerns about the current state of our commercial institutions—in particular, our giant publicly-held corporations—and our giant investment institutions—now largely owned by giant publicly-held financial conglomerates. Both corporate America and investment America represent a peculiar mix of business and profession, but they have moved a long way from the traditional values of capitalism. The origins of modern capitalism, beginning with the Industrial Revolution in Great Britain back in the late 18th century, had to do, yes, with entrepreneurship and risk-taking, with raising capital, with vigorous competition, with free markets, and with the returns on capital going to those who put up the capital. Central to these values of early capitalism was the fundamental principle of trusting and being trusted. But by the latter part of the 20th century, we were to witness the erosion of the very structure of capitalism.

brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment. Benjamin Graham, Right Again Graham was right (of course!) It is hardly news to this audience that the emphasis on future expectations noted by Graham continues to be pervasive today. The desire to quantify and model all aspects of our financial lives has carried the day. Even our learned financial journals are peppered with papers offering abstract models that purport to beat the market. But for me, I’m reminded of Albert Einstein’s famous observation: “Not everything that counts can be counted, and not everything that can be counted counts.” As investment professionals, money managers, and security analysts, we ought to focus primarily on investing based on long-term intrinsic corporate value rather than speculating on short-term, even momentary prices in the stock market. It is not the ephemeral perception of the price of a stock that varies from moment to moment that counts; it is the enduring reality of intrinsic value—however difficult to discern that counts. Make no mistake, the worth of a corporation is still neither more nor less than the discounted value of its future cash flows. So financial professionals need a new primary focus—on security analysis rather than market analysis.

” The way to investment success is to get out of the expectations market of stock prices and cast your lot with the real market of business. Simply heed the timeless distinction made by Benjamin Graham, legendary investor, author of The Intelligent Investor, and mentor to Warren Buffett. He was right on the money when he put his finger on the essential reality of investing: “In the short run the stock market is a voting machine . . . (but) in the long run it is a weighing machine.” 3. Who Earns the Stock Market’s Returns? But whatever returns the stock market is generous enough to deliver in the years ahead, please don't make the mistake of thinking that investors actually earn those returns. To explain why this is the case, we need only to return to that first relentless rule of humble arithmetic that explains the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs of investing are deducted.amount

Portfolio managers, in what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation [Keynes’s enterprise], rather than the public appraisal of the value of a share, that is, its price [Keynes’s speculation].” Alas, the steady sophisticated, enlightened, and analytic demand I had predicted from our expert professional investors is now nowhere to be seen. Quite the contrary! Our money managers, following Oscar Wilde’s definition of the cynic, seem to know “the price of everything but the value of nothing.” Portfolio turnover of equity mutual funds, then running steadily about 15 percent, year after year—has soared in recent years to more than 100 percent—an average holding period of less than one year. So, a half-century-plus after I wrote those words in my thesis, I must reluctantly concede the obvious: Keynes’ sophisticated cynicism was right, and Bogle’s callow idealism was wrong. But that doesn’t mean we should let that system prevail forever.

We live in wonderful and sad times—wonderful in that the blessings of democratic capitalism have never been more broadly distributed around the globe, sad in that the excesses of that same democratic capitalism have rarely been more on display. The rampant greed that has overwhelmed our financial system and our corporate world runs deeper than money. Not knowing what enough is subverts our society’s traditional values, as self-interest and greed replace community interest, and service to self takes priority over service to others. Unchecked, our failures ultimately result in the corruption of our character and our values. So in a broader sense, we all bear some of the responsibility for what has gone wrong in America.

had been severed. His intellectual analysis and his market-moving power, it turns out, were based on a false premise. To his credit, in his testimony before Congress last October, Greenspan admitted his mistake. He acknowledged that the crisis had been prompted by “a once-in-a-century credit tsunami,” which had arisen from the collapse of a “whole intellectual edifice.” “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief,” he said. This failure of self-interest to provide self-regulation was, he said, “a flaw in the model that I perceived as the critical functioning structure that defines how the world works.” It’s worth dwelling on that phrase: “the critical functioning structure that defines how the world works.” As the New Yorker writer John Lanchester observed: “That’s a hell of a big thing to find a flaw in.” Here’s another way of describing that flaw, Lanchester continues: “the people in power thought they knew more than they did. The bankers evidently knew too much math and not enough history—or maybe they didn’t know enough of either.” To which I would add, enough indeed! Bernard Madoff and How We Fool Ourselves Next, let’s turn to issue number two, how we fooled ourselves in the financial markets, where investors—individual and institutional alike—seemed to lose all perspective.

“There is a compelling history to be written about the founding and evolution of the Vanguard Group: Unfortunately, Mr. Bogle’s latest book isn’t it…. (the book) feels like the leftovers from the files of one of investing’s great innovators.” While the 28 reader reviews of Bogle on Mutual Funds were also almost uniformly five- star on Amazon.com, the sole poor rating (three-stars) described it as having “useful ideas but poor conclusions. Like most MBAs, (Bogle) does not know how to use mathematics or empirical conclusions.” (For the record, I don’t even have an MBA.) Barron’s was also tough: “I liked this book the best, but reluctantly. Reluctantly because everyone from Warren Buffett to Money magazine loves it and it’s more fun to deflate the self-righteous than to encourage them.” And while the lion’s share of the 61 reader reviews on Amazon.com about Common Sense on Mutual Funds were also five-star, that didn’t keep one reader from writing “excellent but boring;” another, “Bogle is dead wrong;” and yet another, “save some cash and skip this book.”

Our self-centered “bottom-line” society, focused on money over achievement, charisma over character, and the ephemeral over the eternal. And finally, the paucity of leaders who are willing to, well, lead—to defy the conventional wisdom of the day and to stand up for what is right and noble and true. So the risks are high; the uncertainties rife. Yet perhaps we’ll muddle through. After all, throughout our 230-year history, America has always done exactly that. Perhaps, once again, our society and our economy will continue to reflect the resilience that they have demonstrated in the past, often against all odds. And perhaps we’ll come to our collective senses and develop the courage to take arms against this sea of troubles I’ve described and by opposing, end them. If we do, the stock market will undoubtedly respond and resume the upward course that is based on the intrinsic economic value of business growth. Let me close by acknowledging that I’m conservative and, I’m well, getting on in years, I’ve followed my own advice and am about 68 percent in bonds and 32 percent in stocks—all Vanguard and overwhelmingly in index funds. But each of us is different. So even if risks are high and uncertainties abound, we must consider not only the probabilities of our investment decisions, but the consequences that we face if we are wrong.famous

Hevesi has pleaded guilty and awaits sentencing; Mr. Morris is said to have agreed to a guilty plea to a single felony. Mr. Rattner has not yet settled with New York or Federal regulators, but it can’t help his case that his former advisory firm, Quadrangle, has described his actions as “inappropriate, wrong and unethical.” His punishment, if any, remains to be seen. I’ve chosen these three examples out of scores—even hundreds—of examples, reluctantly leaving out that pillar of probity, Bernard Madoff. While his long jail sentence for his crimes surely is fair punishment, the hedge fund managers whose clients paid them some $500 million for the privilege of having Mr. Madoff defraud them remain scot-free. But the fact is that a disturbingly high percentage of the violations of law and of traditional ethics have occurred in the financial field, where the financial rewards are simply too tempting to ignore. The traditional emphasis on professional standards and fiduciary behavior focused on preserving and enhancing the wealth of clients has given way to business standards aimed at acquiring and accumulating wealth for agents, ethical principles be dammed. III. Vanguard – Structure, Strategy, and Values There is a better way. So in this third and final section of my remarks this afternoon, let me turn to some reflections on Vanguard and the structure, strategies, and values that have brought us to the pinnacle of the mutual fund industry—the largest fund manager in the world.

Pascal wager, conceived as a bet on whether or not God exists. (Pascal concluded that, considering the consequences, the safer bet was that He existed.) As Peter Bernstein explained the wager, “considering the consequences of being wrong is essential in decision-making under uncertainty.” So I urge you all not only to weigh the probabilities of where our markets and our economy are headed in this age of turbulence and uncertainty, but also weigh the consequences to your own portfolios if you are wrong. If you follow these rules, you’ll be able to ride out today’s risks and uncertainties with favorable consequences.

The fact is that the Vanguard is simply different from our peers, unique in our field. We are in fact a group of truly mutual mutual funds, structured so that our management company is owned directly by our funds and their shareholders, operating on an at-cost basis for the benefit of our owners. Our rivals are not “mutual” in any sense of the word. (That is why in my recently published book Don’t Count On It!, the section on “What’s Wrong with ‘Mutual’ Funds” includes quotation marks around the word mutual.) They are operated for the benefit of profit- making corporations, in business to earn a profit on their own capital. Of course, they also want to earn profits for the shareholders of their funds. But in the long run, these managers as a group are destined to produce market-like performance before costs.and

Who Actually Earns the Market’s Returns? In my view, then, we are looking ahead to a decade of returns in the financial markets that are well below historical norms (9 percent for stocks, 5 percent for bonds), albeit a decade in which equities seem highly likely to provide a significant return premium over bonds. But please remember this: the returns I have projected are not of the real world. They are the theoretical returns delivered by the stock and bond markets, before the deduction of investment costs. That raises this crucial question: Just who is it that earns the returns generated in our financial markets? Answer: Very few investors. So whatever returns the financial markets are generous enough—or stingy enough—to deliver, please don’t make the mistake of thinking you will actually earn those returns. Of course all investors as a group must necessarily earn precisely the market return. But they do so only before the costs of investing are deducted. After these costs are taken into account—all of the advisory 3 My own 5.4 percent expectation for nominal returns entails an assumed 2.5 percent inflation rate for a real return of 2.9 percent, virtually identical with Cliff’s figure.

and peers. But soon, perhaps, many others will ultimately see the light. Only last week the idea of governance reform got encouraging support from Professor Andrew W. Lo of M.I.T., one of today’s most respected financial economists: . . . the single most important implication of the financial crisis is about the current state of corporate governance . . . a major wake-up call that we need to change (the rules). There’s something fundamentally wrong with current corporate governance structures, (and) the kinds of risks that typical corporations face today. In sum, the change in the rules that I advocate—applying a federal standard of fiduciary duty to their clients for institutional money managers—would be designed in turn to force these managers to use their own ownership position to demand that the managers and directors of the corporations in whose shares they invest honor their own fiduciary duty to the holders of their shares. Finally, it is these two groups that share the responsibility for the prudent stewardship over corporate assets and investment securities alike that have been entrusted to their care, not only reforming today’s flawed and conflict-ridden model, but developing a new model that, at best, will restore traditional ethical mores. And so I await—with no great patience!—the return of the standard so beautifully described by Justice Cardozo all those years ago, excerpts from his words cited earlier in my remarks: Those bound by fiduciary ties . . .